Annual Recurring Revenue (ARR) is a key metric used by Software as a Service (SaaS) companies to measure the predictable and recurring revenue generated from customers over 12 months. Since SaaS companies bill their customers on a subscription mode, ARR is the sum of all subscription revenue that a SaaS company expects to receive from its customers each year.
For example, if a SaaS company sells Company Z a three-year subscription worth $36,000 in total, in which payments of $1000 are made monthly, then the ARR from Company Z is $12,000.
ARR is a among the most useful metrics for SaaS companies because it provides insight into the health and predictability of their future revenues, and can be used to project future growth and make actionable plans.
It is also a key performance indicator (KPI) used by investors to evaluate the financial performance of a SaaS company.
A high ARR indicates that the business is generating a significant amount of revenue and has a strong customer base, while a low ARR may indicate that the business is struggling to acquire and retain customers.
In addition to being a KPI, ARR is also used to calculate other important metrics such as customer lifetime value (LTV) and customer acquisition cost (CAC). LTV represents the total revenue a customer is expected to generate over their lifetime, while CAC represents the cost of acquiring a new customer.
Factors that Affect Annual Recurring Revenue
New Sales: When you make a new sale, the revenue generated from that sale will increase your ARR. For example, if you sell a new subscription for $1,000 per year, your ARR will increase by $1,000.
Renewals: When a customer renews their subscription, the revenue generated from that renewal will also increase your ARR. For example, if a customer renews their subscription for $1,000 per year, your ARR will increase by $1,000.
Cross-sell: When you sell additional products or services to an existing customer, the revenue generated from those sales will increase your ARR. For example, if you sell a new product to an existing customer for $500 per year, your ARR will increase by $500.
Upgrades/Downgrades: When a customer upgrades their subscription, the revenue generated from that upgrade will increase your ARR. Conversely, when a customer downgrades their subscription, the revenue generated from that downgrade will decrease your ARR. For example, if a customer upgrades their subscription from $500 per year to $1,000 per year, your ARR will increase by $500. Similarly, If a customer downgrades their subscription from $1,000 per year to $500 per year, your ARR will decrease by $500.
How to Calculate Annual Recurring Revenue?
Before we dive into the ARR formula, let's look at the factors that need to be looked at to calculate Annual Recurring Revenue (ARR).
To calculate Annual Recurring Revenue (ARR) using contract value:
Determine the contract length: This is the length of time that the customer has committed to using your product or service. For example, a three-year contract under a subscription model means they are going to keep contributing to your annual revenue for the coming 3 years.
Calculate the contract value: This is the contract's total value over the contract length. For example, if the customer signs a three-year contract for $12,000, the contract value is $12,000, and the annual revenue from it under a subscription business model would be $4,000 per year.
Divide the contract value by the contract length: This will give you the Annual Recurring Revenue (ARR). For example, if the contract value is $15,000 and the contract length is three years, the ARR would be $15,000 divided by 3 or $5,000 per year.
Note that this method assumes that payments are regular in frequency and are of fixed amounts, so that the entire contract value is distributed over the contract length evenly. This is the essence of the subscription mode. SaaS companies sell software as a service customers can subscribe to by paying monthly or annual subscription charges.
Annual Recurring Revenue (ARR) Formula using Monthly Recurring Revenue (MRR)
ARR: To calculate ARR, we multiply the MRR by 12 (the number of months in a year).
How is Annual Recurring Revenue (ARR) different from Annual Contract Value (ACV)?
While Annual Recurring Revenue (ARR) and Annual Contract Value (ACV) are both important metrics used to measure the revenue generated by SaaS companies, they represent slightly different calculations.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers. It is calculated based on the sum of all subscription revenue that a SaaS company expects to receive annually from its customers.
In contrast, ACV represents the total value of contracts signed with customers over 12 months. It takes into account any one-time fees, such as setup fees or professional services fees, that may be included in the contract in addition to recurring subscription revenue.
To illustrate the difference between ARR and ACV, let's consider an example.
Suppose a SaaS company signs a 12-month contract with a new customer for a monthly subscription fee of $100. In addition, the contract includes a one-time setup fee of $1,000. Using this scenario,the ARR for this customer would be $1,200 ($100/month x 12 months), while the ACV would be $2,200 ($1,000 setup fee + $100/month x 12 months).
So, in summary, ARR focuses solely on the recurring revenue generated by a SaaS company from its customers, while ACV takes into account any one-time fees included in contracts signed with customers. It is the annualized value of money coming in from contracts.
How is Annual Recurring Revenue (ARR) Related to Monthly Recurring Revenue (MRR)?
Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are closely related metrics that are often used by SaaS companies to measure their revenue streams.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers.ARR is calculated by multiplying the average monthly recurring revenue (MRR) per customer by the total number of customers in a given period, and then multiplying that by 12 (the number of months in a year). ARR can also be calculated from the contract value
MRR, on the other hand, represents the predictable and recurring revenue that a SaaS company generates from its customers every month. It is calculated by taking the monthly subscription fees per customer in a month and multiplying it by the number of customers.
MRR is a valuable metric because it provides insight into the health and predictability of a SaaS company's revenue stream on a month-to-month basis. By tracking changes in MRR over time, SaaS companies can identify trends and make adjustments to their pricing or marketing strategies as needed.
ARR is a more holistic view of a SaaS company's revenue stream, as it takes into account the total revenue generated from customers over 12 months or a year. While MRR provides a more granular view of monthly revenue, ARR provides a broader perspective on the overall financial health of a SaaS business.
How oes Annual Recurring Revenue (ARR) Contribute to Customer Lifetime Value (LTV)?
Annual Recurring Revenue (ARR) and Customer Lifetime Value (LTV) are two key metrics used by SaaS companies to measure the financial performance of their businesses, and they are related to each other.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers. In contrast, LTV is a metric that calculates the total revenue a SaaS company expects to receive from a customer over the entire duration of its relationship with the company.
To calculate LTV, you need to know several other metrics, such as customer acquisition cost (CAC), customer churn rate, and average revenue per account (ARPA). Once you have these metrics, you can calculate LTV by multiplying ARPA by the gross margin and then dividing that by the customer churn rate. The result is the expected revenue a company will earn from a customer over their entire relationship with the company.
So, how are ARR and LTV related? ARR is one of the key components used to calculate LTV. Specifically, the ARPA metric used in the LTV calculation is equal to ARR divided by the total number of customers. In other words, ARR is a measure of the predictable, recurring revenue generated by each customer, and this information can be used to estimate the average revenue a customer will generate over their lifetime with the company.
In summary, while ARR provides a snapshot of a SaaS company's annual recurring revenue, LTV takes a longer-term view of the revenue generated by each customer over their lifetime with the company, and ARR is a key component used in the LTV calculation.
How to Calculate ARR MRR, ARPA, TCV, ACV, and LTV for a SaaS Business:
Let's walk through an example to illustrate how Monthly Recurring Revenue (MRR), Annual Recurring Revenue (ARR), Annual Contract Value (ACV), and Customer Lifetime Value (LTV) are calculated.
Suppose a SaaS company offers its product for a
Monthly subscription fee of $100; and a
One-time setup fee of $500 for new customers
Monthly Recurring Revenue Calculation
To calculate MRR, we simply multiply the number of customers by the average monthly subscription fee. In this case, the MRR would be $100,000 ($100/month x 1,000 customers).
Annual Recurring Revenue Calculation
To calculate ARR, we multiply the MRR by 12 (the number of months in a year). The ARR for this SaaS company would be $1,200,000 ($100,000/month x 12 months).
Average Revenue Per Account Calculation
ARPA(Average Revenue per Account) per month = MRR / Number of Customers = $100,000 / 1,000 = $100
Customer Lifetime (in years) = 1 / Churn Rate = 1 / 0.1 = 10 years
LTV = ARPA x Customer Lifetime = $100 x 10 yrs x 12 months/yr = $12,000
If the company signs a two years contract then:
TCV:Total Contract Value = Monthly Subscription * 24 + One Time Setup = $100 * 24 + $500 = $2,900
Annual Contract Value Calculation
To calculate ACV, we need to take into account any one-time fees included in contracts signed with customers. Therefore, the ACV would be $2,900/2 years.
ACV = TCV / Contract Term Length in Years.
Lifetime Value Calculation
To calculate LTV, we need to know several other metrics, such as customer acquisition cost (CAC), and customer churn rate. Let's assume the CAC is $1,000, the churn rate is 10% per year. Using these metrics, we can calculate LTV as follows:
LTV = ARPA / Churn Rate = $1000 / 0.1 = $10,000
So, in summary:
MRR = $100,000
ARR = $1,200,000
ARPA = $100 monthly
TCV = $2,900
ACV = $1,450
LTV = $12,000
These metrics provide valuable insights into the financial performance of the SaaS company and can be used to make informed decisions about pricing, marketing, and customer acquisition strategies.
If you're interested in learning more, here's an in-depth video explanation by Chargebee.
FAQs
Is ARR the same as revenue?
ARR (Annual Recurring Revenue) represents the recurring subscription revenue over a year. While it's a subset of total revenue, it specifically focuses on the predictable and recurring aspects of a SaaS business, excluding one-time or non-recurring revenue sources.
Why do companies use ARR?
Companies use ARR (Annual Recurring Revenue) to gauge the predictable, recurring portion of their revenue from subscription-based services. It provides insights into long-term revenue stability, aids in financial planning, enhances valuation metrics, and serves as a key performance indicator for SaaS businesses.
What is a good ARR number?
A good ARR number varies based on company size, industry, and growth stage. Generally, healthy SaaS companies aim for significant ARR growth year-over-year. Investors often look for consistent growth rates and a high ARR to valuation ratio when evaluating the financial health and potential of a SaaS business.
What is an example of annual recurring revenue?
An example of Annual Recurring Revenue (ARR) is a SaaS company earning $100,000 per month from subscription fees. The annual recurring revenue would be $1.2 million, reflecting the predictable, recurring income from its customer base over a year.
How is ARR higher than revenue?
ARR (Annual Recurring Revenue) can be higher than total revenue when it focuses solely on recurring subscription income and excludes one-time or non-recurring revenue sources. It provides a predictable, stable measure of a SaaS company's subscription-based revenue over a year.
How do you convert ARR to revenue?
ARR (Annual Recurring Revenue) is often a subset of total revenue. To convert ARR to revenue, consider additional sources like one-time fees. Total revenue includes all income streams, while ARR specifically focuses on recurring subscription revenue, providing a predictable measure for financial planning and analysis.
Does ARR show profitability?
No, ARR (Annual Recurring Revenue) alone does not show profitability. It indicates the predictable, recurring portion of revenue but doesn't account for expenses. To assess profitability, one must consider costs, customer acquisition expenses, and other financial metrics in conjunction with ARR.
How do SaaS companies calculate ARR?
SaaS companies calculate ARR (Annual Recurring Revenue) by multiplying the monthly or quarterly recurring revenue by 12 or 4, respectively. This provides a reliable measure of the predictable, recurring income from subscription-based services over a year.
What is the difference between MRR and ARR?
Monthly Recurring Revenue (MRR) measures subscription income on a monthly basis, while Annual Recurring Revenue (ARR) provides a yearly snapshot. ARR is MRR multiplied by 12. Both metrics focus on the predictable, recurring portion of revenue in SaaS businesses.
What is the difference between ACV and ARR?
While ACV (Annual Contract Value) refers to the total annualized value of contracts including one time and setup fees, ARR is only concerned with the repeating and predictable revenue arising out of selling subscriptions.
What is the ARR Formula?
ARR (Annual Recurring Revenue) can be calculated by either dividing the contract value by the contract length, or by multiplying the monthly subscription fees per customer by the number of customers.
Visdum Blog
Resources to supercharge your Sales commission plans
.svg)
CustomersPricing
