Metrics can be game-changing when used right. One such metric that can give you an understanding of your recurring revenue business health, help you with better forecasting, and influence your growth strategy is Annual Recurring Revenue.
So, what exactly is ARR?
What is Annual Recurring Revenue?
When you run a subscription model business, don’t you want to determine how much you can earn over a period of time from your subscribers? We’re sure that you do want to. Annual Recurring Revenue is a crucial metric that shows how much revenue your business expects to make annually on a recurring basis.
ARR includes the subscription fee for your product, plus additional services like installation, training, maintenance, etc.
How to Calculate ARR?
In simple terms, ARR is the total recurring revenue you expect from your paying customers annually. Though you shouldn’t include one-time fees, set up fees, and non-recurring add ons while calculating ARR.
Here’s how to calculate ARR if your customers are on monthly billing.
Firstly, divide the total contract value by the total length of the contract in months.
For example, if your customer signs a contract of $45,000 for a period of 18 months, then divide 45,000 by 18, which will 2,500. Then multiple it by 12 to arrive at the ARR.
ARR = (Total contract value/Length of contracts in months)*12
When you bill annually, use the below formula to calculate ARR.
ARR = (Total Contract Value) / (Length of contract in years)
For instance, if your customer signs a 2-year contract of $50,000, then the ARR will be,
ARR = 50,000/2 = $25,000
What to Include in Your ARR?
Recurring Invoices
Include all recurring elements of your subscription model like the monthly fees, and recurring charges per seat/user, etc.
Revenue Upgrade
When you upsell to your customer and they move to a higher plan, the recurring revenue increases as well. Ensure that you take the revised amount to calculate ARR.
Revenue Downgrade
On the other hand, your customers may also move to a lower plan, which would reduce the recurring revenue from the customer. This has to be a part of the ARR calculation as well.
How does ARR help your business?
Helps you to Forecast revenue
ARR gives you a picture of how much revenue you expect to earn year over year. Cross-reference your ARR acquisition targets, pricing strategies, and churn percentages to get an understanding of whether your business is heading in the right direction. You’d also be able to identify the areas that need to be addressed, and can decide accordingly.
Enable to Set Realistic Goals
With better forecasting, you’d be able to set goals that are challenging, yet realistic for your business. You can shift your focus to the areas of opportunities in your business and can make decisions based on them.
Decrease Churn
Calculating the ARR can come in handy in understanding the revenue lost due to churn and downgrade. You’d know that you aren’t doing enough to tackle churn. Use your ARR and figure out how you can make changes to your plans so that you keep your churn to a minimum.
Guide Sales Teams
By calculating ARR for a specific territory, or sales team, you’d know which individuals and teams would need guidance on closing deals, or capturing a higher percentage of renewals. You can act accordingly based on the information you get.
Monitor Your Business’s Health
How do you know whether your business is in a good position? You need metrics to measure this objectively, and ARR can be your answer. By keeping a track of your exact annual revenue, you’ll get a clear understanding of your business’s health, and give you a picture of where your revenue keeps increasing, and where it decreases.
Final Thoughts
ARR can be vital in helping you know how you are performing as a business. If maximizing your revenue growth is what you look for as a business, which you eventually should, then make sure that you properly keep track of your ARR, which can also show you the best way forward.
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