What are the ARR components and why do you need to measure them?
ARR components: what exactly goes into the calculation of ARR? There can be significant confusion over the term itself, its usage, and the measurement of ARR or Annual Recurring Revenue because it feels and sounds like a measure of “revenue” in the traditional context of GAAP revenue.
However, ARR components are not necessarily a measure of recognized revenue. It can and usually is calculated very differently, and is most certainly for a different purpose.
For your organization, you define “Annual Recurring Revenue,” and most importantly, the rules for calculating and presenting it. When communicating information about your Annual recurring revenue with people outside your organization, it’s important to understand your definition and computations and be able to communicate the logic and rationale behind the definitions and calculations when presenting your ARR metrics to venture firms and investment bankers.
ARR is a measure of the predictable and recurring revenue components of a business such as subscriptions or maintenance. ARR components always exclude one-time fees and for most organizations, would exclude variable, usage, and consumption fees.
ARR is a metric sometimes used by subscription businesses employing annual or multi-year term agreements. Like the more common and popular MRR or Monthly Recurring Revenue metric, ARR is a metric representing the normalized value of recurring revenue. And while sometimes used in businesses with annual or longer terms, Annual Recurring Revenue is a metric rarely used in a monthly subscription model or in a hybrid monthly/annual business.
For most businesses, what is important about ARR is the growth momentum for the typical components of your Annual Recurring Revenue:
- ARR added from new sales
- ARR retained from renewals
- ARR added from upgrades and upsets in mid-term or at renewal time
- ARR lost from downgrades and product changes in mid-term or at renewal time
- ARR lost from churned customers or revenue
ARR for these components is frequently measured in both absolute and relative values and is often presented in the context of incremental changes from period to period.
In the report below, you’ll see the relative contribution to the total ARR for new subscriptions and renewal subscriptions. The report below might be typical of an early-stage business where new sales significantly outpace renewals. As the business matures and hits a key inflection point, the percent of total ARR contributed by New Subscriptions will begin a steady decline, assuming churn rates are reasonable.
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