Annual Recurring Revenue (ARR)
What is ARR?
ARR is an acronym for Annual Recurring Revenue, a key metric used by SaaS or subscription businesses that have term subscription agreements, meaning there is a defined contract length.
It is defined as the value of the contracted recurring revenue components of your term subscriptions normalized to a one-year period. ARR is the less frequently used alternative normalization method of the two common ones, ARR and MRR. It is used almost exclusively in B2B subscription businesses.
How do I calculate ARR?
To effectively use ARR as a metric in your business, you must have term agreements with a minimum duration of one year, or the majority of your term agreements must be one year or more. It is typically adopted by subscription businesses with multi-year agreements.
There are no defined rules for the determination of what to include in ARR. Typically, it will include only contractually committed, fixed subscription fees.
Since one-time fees are by definition non-recurring, they are almost always excluded from ARR calculations.
Subscription consumption fees and variable fees are also typically excluded from ARR calculations; however, an argument can be made to include predictable consumption fees or at least the contracted minimal committed consumption fees.
Unlike MRR, which is a metric that can vary dramatically from GAAP revenue due to the variance in days in the month, ARR can correlate well with GAAP revenue if your subscriptions are in annual or true multi-year intervals.
However, you can experience an “MRR-like” jitter issue if your term subscriptions run for non-standard lengths, such as 15 months or 30 months and eight days.
In the end, you should have a clear definition of annual recurring revenue and how it is calculated for your organization and be consistent in the calculation of it and communication of metrics within your organization.
What is most important about ARR is the momentum around the components of your company’s ARR:
- ARR from new customers
- ARR from existing customers who renew
- Incremental increases or expansion in ARR from upgrades and add-ons
- Incremental decreases or contraction in ARR from downgrades
- ARR losses, or revenue churn
- ARR for each of these components is often measured and reported in absolute value, relative value, and incremental changes from period to period.
At SaaSOptics, we measure the different components of annual recurring revenue in a report called the subscription momentum report. Below is an illustration of this report:
What is the difference between ARR and MRR?
Very simply, ARR is 12 x MRR. That’s really all there is to it.
So why use ARR vs. MRR?
Objectively speaking, there really are no good answers as to why to use one over the other.
Annual recurring revenue is often used in B2B subscription business when the minimum subscription term is one year. MRR is often used in B2B businesses with monthly subscriptions as well as in B2C subscription businesses.
Annual recurring revenue is frequently adopted by B2B SaaS businesses with multi-year terms and tends to be used in businesses with lower transaction volume and higher transaction value. It is also not uncommon for companies that use this metric to also use MRR.
One trend we’ve observed in companies using both MRR and ARR, they tend to think of ARR as a valuation metric and MRR as an operating metric.
You probably reference your ARR metric in board meetings or in conversation with management, but your MRR metric is often more useful in the day-to-day operations of the business. Because expenses tend to be fairly stable month-over-month in a SaaS business, MRR can be a useful shorthand metric even if you and your management team tend to think in terms of ARR.
Say, for example, your marketing team asks for an incremental budget increase one month. You can make a quick, back-of-the-envelope decision based on your MRR metric minus your typical monthly spend.
If you’re comfortable with the runway you’d be leaving yourself, you can go ahead and greenlight the budget increase.
ARR does have one big benefit – it will align well with your GAAP revenue. While MRR and monthly GAAP revenue can differ significantly in any given month due to the revenue spread and fluctuating days in the month, over a one-year term, ARR is going to be roughly equal to the GAAP revenue for your recurring revenues over that year.
Switching From MRR to ARR
The only real issue with adopting ARR as your standard “normalized” value for recurring revenue performance metrics and analysis is the difficulty of using it with contract terms under a year in duration. (Technically, you can do it, but MRR is much better). The use of annual recurring revenue for contracts less than a year in duration is rarely seen in practice.
As a subscription business grows and experiments with pricing and packaging, it is common to introduce new contract terms.
If or when you do, and you end up with contracts with term lengths less than a year, MRR is the preferred normalized recurring revenue performance metric.
If ARR has been the standard and common company vernacular for discussing recurring revenue, it may be difficult to change to MRR until the volume of the new “shorter” term contracts is such that the benefits warrant the pain of making the change.
Changing communications, culture, measurement, and reporting processes from ARR to MRR (or vice versa) can consume energy and time.
And what about changing from MRR to ARR? Great question, but if that comes up, it has to be rare indeed as it is not something we have ever run into at SaaSOptics.
Do you know which metrics matter for your business?
ARR and GAAP Revenue
There are no set rules for the calculation of ARR, but under most situations, the annual recurring revenue ascribed to a contract element will be equal or roughly equal to the GAAP revenue associated with that contract element.
However, while ARR is representative of GAAP revenue, it is an imprecise financial expression and should never be confused with “reportable GAAP revenue.”
For most efficient business discussions, consider adopting the term “GAAP Revenue” for discussions relating to accounting and income statement/P&L performance, and “ARR,” or “MRR,” for subscription metrics and analytics.
For maximum communication efficiency, ensure each party who consumes the numbers has a clear understanding of the terminology, as well as the rules for the generation of the underlying numbers.
Finance professionals, specifically CPAs, rarely need education on GAAP Revenue, but many are new to the subscription business and need to understand how annual recurring revenue is different from GAAP revenue.
If your business is early stage and your finance person is a bookkeeper, they will likely need education on both topics, as will managers in sales, marketing, and product functions.
How do I use ARR?
In the finance function, ARR is used in or to:
- Report on growth from new contracts, including those with different term lengths
- Report on net & gross expansion and contraction from existing customers
- Assess trends in ASP (average selling price)
- Report on Cohorts (typically by customer start month, quarter, or year)
- Estimate future GAAP revenue
Is there a CARR equivalent to CMRR?
CMRR is an acronym for Contracted Monthly Recurring Revenue.
For term subscription businesses with gaps between order date and subscription go-live dates due to onboarding or simply contract language, CMRR or Committed Monthly Recurring Revenue is the value of the contracted MRR from the booking date through the subscription end date.
Is there a CARR metric equivalent? There is no reason you can’t track and measure CARR, but it is NOT a common term. A google search for CMRR shows plenty of relevant hits, but if you try CARR or “CARR Subscription Metric” you won’t find much.
ARR Reporting in a Spreadsheet
While ARR does approximate revenue, it is still a normalization value, and therefore you will be hard-pressed to find an ARR data field or function in any GL or finance system.
Few billing platforms include ARR, favoring MRR if they have either (SaaSOptics maintains both MRR and ARR).
Need an easy way to calculate MRR and ARR?
Unless your finance system has a rev rec module, it will not have a Contract Object and will likely not track subscription start and end dates. This means “cancellation” actions and churn are challenging to report on in your finance system.
Without support for ARR and cancellations in your finance system, most turn to Excel to track and measure ARR and churn.
While SaaSOptics has significantly evolved tools for ARR reporting, we understand how to track this in spreadsheets as a spreadsheet was the seed from which SaaSOptics sprang (not technically, of course, just conceptually).
To perform core ARR calculations, it is easiest to start with a simple “status” or state spreadsheet.
Your .xls will include basic information needed to report on the present state of each contract or subscription. This approach works well for a few dozen customers, but its value quickly evaporates as a company grows.
Ultimately, this approach does not provide information to report on changes, and what is fundamentally interesting about a subscription company is the change or rate of change.
Using Spreadsheets to Track Subscription Actions
Most organizations move to a transaction or subscription ledger approach in very short order.
This approach mimics a simple database that captures each subscription action (new booking, upgrade, renewal) as a record in the spreadsheet.
To calculate ARR Churn, you need to report on cancellations. Cancellations are essentially the absence of a renewal.
However, measuring a cancellation using an “absence of data” is extremely difficult in Excel. In other words, you need some form of a cancellation record that you can measure.
You can either tag transactions to indicate the transaction did not renew or add a Cancellation transaction with a value (for bookings loss) and an ARR value.
The best-practice approach to create cancellation records is to record the cancellation in the same period as you would record it if it were a renewal. Doing so enables you to consistently measure renewals and churn, a mathematical-must since churn is simply (1 – Renewal Rate).
By way of illustration, a subscription ends on July 31.
If it renews, the new term’s start date is August 1, and therefore the renewal date for ARR calculations is August 1.
If it doesn’t renew, i.e., it cancels, there is a tendency to report the cancellation (especially within the Sales function) as of the end date.
However, in doing so, you are reporting the cancellation in a different period. The cancellation should be recorded on Aug 1, which is the same date and, therefore, in the same period as the renewal had it renewed.
A typical ARR performance report includes ARR totals broken out by the following classes: New, Renewal, Expansion/Upgrade, Contraction/Downgrade, and Lost, as shown in the SaaSOptics ARR Momentum Report above.
While the data management and .xls formulas become increasingly complicated as your business and reporting needs grow, calculation of New and Lost are typically the easiest and can usually be calculated using a data field or flag to indicate the class of a record.
In early-stage subscription businesses, you can also use data fields/flags to indicate the class of a transaction.
However, as the volume of data grows and the complexity of transactions increases, this becomes increasingly complicated.
Mid-term subscription changes for quantity, products, value, and term-end dates all create immediate havoc with the formulas used to calculate Expansion, Contraction, and Renewals in Excel.
Luckily, SaaSOptics’ subscription management function can handle these complicated scenarios with ease and accuracy.
Ready to start simplifying financial operations?