How to calculate Annual Recurring Revenue (ARR)
How to Calculate Annual Recurring Revenue (ARR) for a Term Subscription Business
ARR is an acronym for Annual Recurring Revenue, a metric for SaaS or subscription businesses with term subscriptions. ARR is the value of the contracted recurring revenue components of your term subscriptions normalized to a one year period.
There are no defined rules for the determination of ARR. Typically, ARR will include only committed and fixed subscription or recurring fees. ARR always excludes one-time fees and usually excludes any subscription consumption or variable fees.
Simple ARR Calculation Examples:
- 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
- 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.
- 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.
- 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.
- 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.
- Customer F subscribes to service with a start date of January 17, 2012 and an end date of September 30, 2013 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 to a year. The Excel formula is ($25000/(EndDate – Start Date))*365, or you can use SaaSOptics to generate the value automatically!
In order 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 other notice period, or they simply pay month-to-month, use MRR.
What is important about ARR is not a single number per se, but rather the momentum around the components of your company’s ARR:
- 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
Unlike MRR, which is a metric that can vary dramatically from real monthly revenue due to the variance in days in the month, ARR can correlate well with actual revenue if your subscriptions are in annual or true multi-year intervals. However, you can experience with ARR the same MRR jitter issue if your term subscriptions run for non-standard lengths, such as 15 months, or 30 months and 8 days.
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.