How To Calculate ARR: Important Factors To Include
A Breakdown of ARR (Annual Recurring Revenue)
Any company relying on a subscription business model measures ARR (annual recurring revenue). This critical metric details the annual revenue stream from subscription clients.
The subscription ARR metric can be broken down in several ways and offers vital insights into current and future business trends.
Why ARR Is a Key Metric for Businesses
Annual recurring revenue is the total revenue expected from subscription charges over a year. ARR is an important metric because it assists a company in tracking sales trends, planning operating expenses, and budgeting investments in new products/services.
An upward-trending ARR reflects the success of the subscription model through new customers, upgrades, and renewals. Conversely, a decline in ARR over current or recent months may indicate dropped subscriptions, declining sales, or downgrades in service levels.
A negative trend can assist a company in finding and fixing problems in product offerings, customer relationships, or marketing efforts.
For many companies, ARR is just one metric that can measure multiple income streams. Broken down by department or individuals, it can help a business set goals, assess employees, or calculate bonuses. When employees are paid for performance, it generally improves retention and cuts hiring and training costs.
ARR also contributes to an overall picture of customer relationships and the success of marketing strategies. By following trends in yearly subscriptions — cancellations and renewals — the business gains a deeper understanding of the market and customer needs.
If one subscription product seems to be faltering, as revealed by the ARR projection, the company can consider promotions or free trial periods for that product to boost interest. By measuring predictable revenue, ARR helps a business strategize.
A rising revenue stream offers an opportunity to expand marketing efforts or open new office locations. A company growing its ARR may also consider investing in new products or expanding to foreign markets.
The ARR Formula
Most calculations of ARR include only fixed subscription payments agreed to by contract or a customer's commitment. Non-recurring costs or fees are not included in the calculation. A company may, however, project ARR using expected consumption fees, such as a cable service looking ahead to single pay-per-view events.
ARR based on annual or multi-year contracts is more reliable than a service that is billed month-to-month. Subscriptions that run for irregular terms, such as 18 months, can cause wobbly ARR figures that don't match the final results. Solving this issue means settling on a company-wide definition of ARR and a fixed method for calculating it.
An ARR Calculation Example
A simple example will illustrate how to calculate ARR.
A service/repair contract that covers three years may charge the customer $3,600. Although one-time fees (for non-repair site visits, for example) may be charged according to the contract, these are not included in annual recurring revenue. The ARR metric from this account is $1,200: $3,600 divided by three (for the three-year contract).
If, after the three-year period, a month-to-month renewal is offered for 18 months — at $150 per month — the ARR would change to $1,800, the annualized rate of the monthly charges: $150 per month multiplied by 12 months.
ARR that holds steady — or declines — may signal to pull back on operating expenses or raise new capital through loans or stock issuance. Problem areas can be identified with an ARR projection, allowing the company to address any issues more quickly.
Investors also like to see a rising ARR and its contribution to expected revenue over the coming months and years. Subscription payments, as contractual obligations, are generally more reliable than one-time sales or fee income. This allows potential and current shareholders to more easily project the all-important quarterly net income number, which the stock market relies on as a key indicator.
Subscription businesses can break down ARR in several ways. It can be applied to new or existing customers and different subscription products. It can also be derived from contract add-ons and upgrades.
The effect of downgrades in service can also be measured. Customer churn, meaning the rate of canceled or unproductive accounts, can also be revealed by an analysis of ARR. ( See 3 Subscription Billing Metric That Matter).
ARR vs. MRR (Monthly Recurring Revenue): The Difference
While many service businesses employ annual contracts, others may also offer monthly agreements at a higher rate. The advantage to the customer is the opportunity to end the obligation before a year is out. The vendor, however, prefers a reliably longer-lasting income stream and thus offers a discounted rate for a more extended period.
MRR is monthly recurring revenue. Some businesses using a subscription model use monthly contracts. For example, a gas utility may offer appliance repair coverage as an add-on to a monthly bill. If such a company can only reliably project by monthly amounts, the rate charged for one month can be multiplied by 12 to arrive at annual recurring revenue.
Annual recurring revenue is common in businesses that sell software as a service (SaaS). An accounting system, with technical support offered, may come with a term of several years. It's common to apply this metric to the valuation of a product or the company as a whole. MRR is more helpful in gauging the capacity to meet operating expenses.
MRR can be used in short-term budgeting decisions. For example, expenses related to a seasonal marketing campaign may or may not be covered by the expected MRR. The same would go for hiring decisions, such as boosting customer support staff or hiring paralegals for a one-time document review project.
The ARR calculation is roughly equivalent to annual revenue as measured by generally accepted accounting principles (GAAP). Because of the varying number of days in the month, monthly recurring revenue is less closely aligned with monthly GAAP income.
A Payment Platform That Reduces Churn Rate for Optimal ARR Growth
Key features of a payments platform for optimal ARR growth include network compliance, routing, security, data optimization, and reducing churn (cancellation rate). Founded in 2020, Revolv3 improves online merchants’ recurring billing approval rates and reduces customer churn at the lowest cost in the market.
Revolv3's system scales with the growing merchant client that needs to farm out billing, a routine but vital task which can overwhelm companies experiencing rapid growth. Learn more by requesting a demo at Revolv3.com.
Disclaimer: Nothing in this article constitutes professional and/or financial or accounting advice, nor does any of the information constitute a comprehensive or complete statement of the matters discussed. Readers should use this information to consult with their accounting professionals.
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