How to Use the Annual Recurring Revenue Formula

Formula to calculate annual recurring revenue

 

SEE HOW WE CALCULATE ARR IN YOUR BUSINESS

What is Annual Recurring Revenue?

ARR is the value of the contracted recurring revenue components of your term subscriptions normalized to a one-year period. 

Why is Annual Recurring Revenue Important?

Annual recurring revenue is important because it gives businesses a high-level view of how healthy their recurring revenue growth is. Ideally, you’ll want to see ARR grow from period to period, but decreases in ARR in particular customer segments or cohorts can be a signal that you need to adjust your strategy.

What is important about ARR is not a single number per se, but rather the information that can be learned from the components of your company’s ARR, such as:

  • ARR from new customers
  • ARR from existing customers who renew
  • Incremental increases in ARR from upgrades and add ons
  • ARR losses from downgrades or lost customers, or revenue churn

MRR vs ARR

As soon as you take a look at what ‘MRR’ stands for, the differences between ARR and MRR become quite apparent. MRR stands for ‘monthly recurring revenue’, so rather than representing revenue over the course of a year, MRR is a metric that shows a businesses recurring revenue over the course of just a month.

Unlike MRR, which is a metric that can vary dramatically from real monthly revenue due to the variance in days in a month, ARR can correlate well with your company’s actual revenue if your subscriptions are in annual or true multi-year intervals. However, the same problems that arise with MRR can arise with ARR if your term subscriptions run for non-standard lengths, such as 15 months, 30 months, or 8 days.

To use ARR as a metric in your business, you should have Term Agreements of one year or more (or the majority of your Term Agreements should be one year or more). If your customers have the ability to cancel at any time in the agreement with 30 days or another notice period, or they simply pay month-to-month, you should consider using MRR to measure the health of your business instead.

How to Calculate Annual Recurring Revenue (ARR)

In order to calculate ARR, you first need to gain familiarity with a basic annual recurring revenue formula.

We calculate annual recurring revenue formula as follows:

Total revenue of yearly subscriptions + total revenue gained from expansion + total revenue lost due to churn and contraction = ARR

In other words, ARR is equal to the value of your term subscription’s contracted recurring revenue components, normalized to a one-year period.

While there are no defined rules for the determination of ARR typically ARR will include only committed and fixed subscription or recurring fees. However, your annual recurring revenue calculation should always exclude one-time fees and usually excludes any subscription consumption or variable fees.

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Continue reading to get a feel for how to calculate your own ARR, or learn more about how we can calculate your business’s ARR.

ARR Calculation Examples

Example 1

  • Customer A signs an agreement for a service at a total 3-year subscription cost of $36,000. The contract includes $10,000 or training and professional services.
    • ARR = $12,000
      • Explanation: One time fees excludes. $36,000 / 3 year = $12,000

Example 2

  • Customer B subscribes to a 1-year agreement for $150,000, which includes 4 different subscription components. The customer also commits to $25,000 of training.
    • ARR = $150,000
      • Explanation: One-time fees excludes. $150,000 / 1 year = $150,000. ARR is typically reported in aggregate across sales items.

Example 3

  • Customer C subscribes to a 15-month agreement for $15,000 and no professional services.
    • ARR= $12,000
      • Explanation: $15,000 * (12/15) = $12,000.

Example 4

  • Customer D subscribes to a monthly service at $100 per month and uses the subscription for 24 months.
    • ARR= $0
      • Explanation: Unless the customer is contracted for a term, typically a year or more, there is no ARR.

Example 5

  • Customer E subscribes to a 1-year agreement with monthly billing of $100 per month.
    • ARR= $1,200
      • Explanation: How the customer is billed is really irrelevant. What is important is the value of the contractual commitment. In this case, the customer is contracted for a year at a total value of 12 x $100.

Example 6

  • Customer F subscribes to service with a start date of January 17, 2020, and an end date of September 30, 2021, for a total cost of $25,000
    • ARR= $14,647
      • Explanation: The term is more than a year and not an even number of months. You will need to calculate the days from start to end and normalize them to a year. The Excel formula is ($25000/(EndDate – Start Date))*365, or you can use SaaSOptics to generate the value automatically!

Conclusion

In the end, you should have a clear definition of ARR and how it is calculated for your organization and be consistent in the calculation of it and communication of ARR metrics within your organization.

Need help with all things ARR? Book a demo with us here at SaaSOptics today to learn more about how our suite of SaaS financial tools can help you get the most out of your business metrics.

 

SEE HOW WE CALCULATE ARR IN YOUR BUSINESS

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