What are the ARR components and why do you need to measure them?
There can be significant confusion over the term itself, the use, and the measurement of Annual Recurring Revenue because it feels and sounds like a measure of “revenue” in the context of revenue recognition. However, Annual Recurring Revenue 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 is important to understand your definition and computations and to be able to communicate the logic and rationale behind the definitions and calculations when presenting your annual recurring revenue metrics to analytics, venture firms, and investment bankers.
Annual Recurring Revenue is a measure of the predicable and recurring revenue components of recurring revenue stream such as subscriptions or maintenance. Annual Recurring Revenue components always excludes one-time fees and for most organizations, would exclude variable, usage, and consumption fees.
Annual Recurring Revenue is a metric sometimes used by subscription business employing annual or multi-year term agreements. Like the more common and popular Monthly Recurring Revenue metric, Annual Recurring Revenue is a metric of the normalized value of recurring revenue. And while sometimes used in business 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 Annual Recurring Revenue is the growth momentum for the typical components of your Annual Recurring Revenue:
- Annual Recurring Revenue added from new sales
- Annual Recurring Revenue retained from renewals
- Annual Recurring Revenue added from upgrades and upsets in mid term or at renewal time
- Annual Recurring Revenue lost from downgrades and product changes in mid term or at renewal time
- Annual Recurring Revenue lost from lost customers, or revenue churn
Annual Recurring Revenue for these components is frequently measured in both absolute value and relative value, and often presented in the context of incremental changes from period to period.
In the report below, you see the relative contribution to total annual recurring revenue 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.