Annual Recurring Revenue: What is ARR & How to Calculate It
What is Annual Recurring Revenue (ARR) ?
Annual Recurring Revenue, or ARR, is a metric that shows the money that comes in every year for the life of a subscription (or contract). More specifically, ARR is the value of the recurring revenue of a business’s term subscriptions normalized for a single calendar year. For example, if your subscriber purchases a two-year subscription for $12,000, the ARR would be $6,000 for each year. ARR is predictable revenue that can be counted on every year.
ARR is especially vital for businesses utilizing a subscription model. It provides a clear insight into the company’s revenue streams and aids in forecasting future growth. By analyzing the ARR metric, companies can evaluate their financial performance, assess the success of their subscription offerings, and make informed decisions regarding pricing, product development, and customer acquisition strategies.
Utilizing ARR as a financial metric comes with numerous benefits. It offers a more stable and accurate representation of a company’s revenue compared to one-time sales or sporadic revenue streams, aiding in long-term planning. Additionally, ARR can be used to measure customer loyalty and retention rates, reflecting the recurring revenue from existing customers.
For businesses aiming to attract investors, ARR is a vital metric showcasing potential for consistent revenue growth. It provides investors with a clear understanding of a company’s financial stability and its capability to generate predictable revenue. Furthermore, ARR can serve as a benchmark to compare the performance of various subscription-based businesses and identify industry trends.
How to calculate ARR
To find ARR you must account for all recurring revenues within your business. To do this, subtract the amount of revenue lost from cancellations from the revenue generated by annual subscriptions and upgrades.
ARR calculations can include the following:
Revenue from new and renewing customers
Upgrades and add-ons
Losses from downgrades and lost customers
To calculate ARR divide the total contract value by the number of relative years.
ARR formula
To calculate the ARR, use the following formula:
ARR = (Sum of the year’s subscription revenue + recurring revenue from upgrades and add-ons) – revenue lost from downgrades and cancellations that year.
Remember that any expansion revenue received through upgrades or add-ons will impact the annual subscription price of a customer. One-time selections should not be included in this equation.
You can also calculate ARR by multiplying your monthly revenue by 12.
ARR Example
For example, if a customer signs a four-year contract for $4,000, divide $4,000 (contract cost) by four (number of years) for an ARR of $1,000/year. If a customer declines to renew a $6,000 contract over two years, divide $6,000 (contract cost) by two (number of years) for an ARR decrease of $3,000.
ARR only includes fixed contract fees, not one time charges. Rather, single charges (or variable revenue) should be accounted for separately. If any extra, non-subscription charges are lumped into ARR, accuracy is lost in your calculations.
Billing cycles don’t affect ARR, as long as the term of the subscription is a year or more and the subscription is recorded the same regardless of how payments are structured.
Annual Recurring Revenue (ARR) vs. Other Metrics
When measuring revenue, businesses have various metrics at their disposal. Annual Recurring Revenue (ARR) provides valuable insights into a company’s financial performance. However, understanding how ARR compares to other revenue metrics, its advantages, limitations, and appropriate usage is crucial.
ARR measures the predictable and recurring revenue generated by a company’s subscription-based business model over a year. It considers the annual value of all active subscriptions, excluding one-time fees or non-recurring revenue. This metric offers a clear picture of a company’s revenue stream, particularly useful for subscription-based businesses.
Comparing ARR with other revenue metrics, such as total revenue or monthly recurring revenue (MRR), reveals key differences.
ARR vs Total Revenue
ARR is the recurring revenue from subscriptions, and revenue is an all-encompassing term that describes any type of business income, whether it’s recurring or not.
ARR vs MRR
ARR should be calculated for annual terms — with a one-year minimum. Subscriptions that have terms that are less than one year shouldn’t be recorded in ARR. These types of short-term contracts often allow for subscription cancellation within 30 days. If these subscriptions were calculated as ARR, that would be inaccurate. Instead, shorter-term subscriptions should be calculated as monthly recurring revenue (MRR).
Why is ARR important for a subscription business?
ARR is a good measurement of the health of a subscription business. Because ARR is the amount of revenue that a company expects to repeat, it enables measurement of company progress and prediction of future growth. It’s also a useful metric for measuring momentum in areas such as new sales, renewals, and upgrades — and lost momentum in downgrades and lost customers.
ARR is particularly useful as a metric to:
Clarify company health. ARR measures company performance in specific areas, showing where revenue is growing or being lost and why. Knowing your ARR can help you make better decisions regarding employee assessment, compensation, operational planning, and financing to improve the bottom line and help increase company efficiency.
Increase revenue. Tracking relationship changes provides insight into what customers want and need and helps to promote cross-selling and up-selling, which leads to increased revenue.
Forecast revenue. Planning the duration and cost of different subscriptions helps forecast revenue from potential clients. Tracking the value of renewals and the cost of lost customers (i.e., churn) helps businesses manage expenses more precisely and maintain cash resources.
Retain top talent. Monitoring ARR encourages a business to focus on individual sales territories to determine what’s working and what needs changing. Compensation commensurate with productive job performance results in less turnover and cuts new employee training costs.
Attract investors. Investors prefer the contractually obligated revenue, predictable sales models, and accurate revenue forecasting of the subscription economy over one-time sales. Subscription businesses with ARR can thrive because owners can sell predictably and systematically.
What is ARR growth rate?
ARR growth rate is the adjustment in annual recurring revenue over a period of time, typically depicted as a percentage. Increasing ARR growth rate year after year is usually a sign of product-market compatibility.
What is a good ARR growth rate?
Your business’s ideal growth rate should be between 20% and 50%. Any growth rate under 20% indicates that your company isn’t growing fast enough to succeed in the long run. Growth over 50% doesn’t leave you enough time to increase revenue while keeping up with costs.
How to maximize your Annual Recurring Revenue
Maximizing Annual Recurring Revenue (ARR) is crucial for the success and growth of any subscription-based business. Effective strategies, optimized subscription models, and considering ARR in business planning can drive revenue growth and achieve long-term sustainability.
One key strategy to improve and scale ARR is focusing on customer acquisition and retention. By attracting high-quality leads and ensuring customer satisfaction, businesses can increase their ARR. Personalized experiences, exceptional customer support, and continuously enhancing the subscription’s value proposition can achieve this.
Optimizing subscription business models is another best practice to maximize ARR. This involves analyzing pricing structures, product offerings, and subscription plans to align with customer needs and market trends. Experimenting with different pricing tiers, upselling, cross-selling opportunities, and bundling options can increase the average revenue per customer, boosting ARR.
Regarding business planning and growth, ARR plays a vital role. It provides a clear picture of the company’s recurring revenue streams, allowing informed decisions and realistic goal setting. By tracking and analyzing ARR trends, companies can identify improvement areas, allocate resources effectively, and forecast future revenue growth.
At Zuora, we understand the importance of maximizing ARR for our customers’ success. Our subscription management platform empowers businesses to optimize their subscription models, automate billing processes, and gain valuable insights into their ARR performance. With Zuora, you can unlock the full potential of your subscription business and drive sustainable revenue growth.