For companies that follow the subscription business model, annual recurring revenue (ARR) is a valuable metric that helps to measure the success of their business.
ARR is calculated by taking the revenue received from paying customers over a 12-month period, and subtracting any revenue lost due to cancellations or failed payments. It provides an estimate of future cash flow, which can be used when evaluating finances, making budgeting decisions, and predicting future growth.
What is Annual Recurring Revenue?
Annual recurring revenue (ARR) is a key metric used to measure the success of companies that have adopted the subscription business model. It shows how much revenue can be expected from current customers over the course of 12 months based on their past performance.
The subscription economy is booming, and annual recurring revenue (ARR) is one of the most important metrics for companies that operate in this model.
By calculating and tracking ARR, businesses can measure their success and make informed decisions about their future revenue growth.
Particularly in the Software-as-a-Service (SaaS) industry, ARR is used to measure the amount of money that customers are committing to spend each year on a product or service.
This gives business owners an indication of how successful their offering is, as well as insights into customer loyalty and churn rates.
Many factors can impact ARR, including pricing, customer retention rates, and product churn.
But by understanding what drives revenue growth and analyzing the data collected through regular monitoring, businesses can take steps to improve their ARR and strengthen their position in the subscription economy.
- ARR – The abbreviation for annual recurring revenue, the same as recurring revenue, subscription revenue, and committed revenue.
Annual Recurring Revenue vs. Monthly Recurring Revenue
Annual recurring revenue (ARR) and monthly recurring revenue (MRR) are two metrics that measure the same thing: income generated from ongoing customer subscriptions.
The difference is that ARR takes into account all of the customers who are subscribed for a period of one year, while MRR only looks at those customers who have committed to monthly subscriptions.
In revenue management, it’s important to look at both ARR and MRR to get an accurate picture of a company’s success.
Measuring both ARR and MRR is important because it gives a more complete picture of the business performance.
ARR reflects the total amount of money that customers are committing to spend over the course of a year, while MRR shows how much money is coming in each month from those customers. This information can be used to make strategic decisions about pricing, revenue forecasting, product development, and marketing.
For example, if a company sees its ARR trending downward, it might consider increasing its prices to boost revenue. Or if MRR is higher than ARR, the company might decide to focus on retention and churn prevention strategies to keep more customers locked in for longer periods of time.
By tracking both metrics regularly, businesses can make informed decisions about where they need to focus their efforts to improve their revenue growth.
Why Annual Recurring Revenue is Important
Revenue intelligence is a tricky concept—while financial statements can give businesses a snapshot of the company’s performance, annual recurring revenue provides deeper insight into business trends and customer behavior.
Measures Company’s Growth
Companies using the subscription model can track annual subscription revenue over a one-year period to understand their growth trajectory. The ARR calculation can be used to make decisions about pricing, identify customer churn patterns, and monitor the impact of promotional campaigns.
Measures Success of Subscription Business Model
By looking at the actual revenue generated from subscriptions, businesses in the subscription economy can measure the success of their model. Companies relying on a subscription-based revenue stream can use this information to make decisions about optimizing product features and pricing levels.
Helps Forecast Revenue
Using the ARR metric, businesses can forecast future revenue and identify opportunities to increase revenue growth. This metric can also help in setting realistic business goals and identifying areas where improvements need to be made.
Improves Revenue Optimization
Revenue optimization is the practice of maximizing revenue while minimizing expenses. This can be done through a variety of methods, including pricing, product mix, and sales and marketing strategies.
When it comes to subscription businesses, revenue optimization is key to success. By understanding how ARR impacts revenue growth, businesses can make decisions about pricing, product development, and marketing that will improve their bottom line.
How to Calculate ARR
ARR calculations are simple and straightforward—total the amount of recurring revenue over a given period (usually one year) to get the total ARR.
Let’s take a look at this more in-depth.
The formula to calculate ARR is:
ARR = (Total Revenue from Subscriptions + Revenue from Upsells and Expansion Revenue) - (Churn Rates + Downgrades + Contract Renewal Discounts)
Conversely, ARR can be calculated by multiplying MRR by 12. This method is more common for companies that offer multiple subscription plans with different monthly rates.
What to Include in Annual Recurring Revenue
The annual recurring revenue calculation includes a few key components:
- Overall revenue from subscriptions: This is the total amount of money that customers are paying each month, plus any setup fees or one-off payments.
- Number of customers: The number of customers who have committed to an annual contract term.
- Length of contract: The length of the customer’s commitment to the subscription. Typically, this is one year, but many companies also offer multi-year contracts.
- Add-ons and upgrades: Any additional services or products that customers may have added to their subscriptions.
- Revenue lost from churn: The amount of money lost from customers that have canceled their subscriptions before the end of the annual contract period.
- Discounts and promotions: Any discounts or promotional offers that may have been applied to the subscription rate.
By understanding the components of ARR, businesses can get a better sense of how changes in pricing or customer engagement will impact their bottom line.
What to Not Include in Annual Recurring Revenue
ARR calculations should not include the following:
- One-time payments: Any payments that are not recurring, such as setup fees or one-off payments.
- Revenue from non-recurring customers: Customers who have purchased a subscription for less than one year, such as those on a quarterly or monthly plan.
How to Increase Annual Recurring Revenue
There are a few key ways that companies can increase their ARR:
1. Increase customer engagement
The fastest way to boost ARR is to increase engagement with customers.
This could be done using CRM software, loyalty programs, or other customer-centric strategies.
Businesses can also improve their customer engagement by offering special discounts to encourage customers to commit to an annual contract.
2. Optimize product features
By offering unique product features or incentives, businesses can differentiate their products and make them more attractive to potential customers. This could include offering add-ons or bundle packages at discounted rates, as well as providing better customer support.
3. Adjust pricing levels to meet consumer demand
Price optimization is critical to increasing ARR. Companies must be aware of their competitors’ pricing levels and adjust theirs accordingly. They should also consider offering incentives or discounts that promote annual revenue instead of monthly revenue (e.g., a 10% discount to customers who prepay for a year).
4. Invest in marketing
Marketing is a key component of any successful business, and it can help to increase ARR by driving more customers to the company’s subscription offerings. Companies should invest in marketing efforts such as pay-per-click campaigns, social media advertising, content marketing, and email campaigns.
5. Upsell, cross-sell, and add-on
Upselling, cross-selling, and offering add-ons can be effective ways to boost ARR. Businesses should look for opportunities to offer additional services or products that are related to their subscription offerings, such as discounted upgrades or bundle packages.
This can be done for new customers, but inside sales teams should also be reaching out to existing customers to offer additional services or products that they may find valuable.
Who Should Use the ARR Model?
The ARR model is most commonly used by companies in the subscription-based economy. This includes software-as-a-service (SaaS) businesses, streaming services, service-based businesses that use the retainer model, and subscription box companies.
Companies that do not have predictable revenue might not benefit from using the ARR model as a metric. And companies with a billing cycle that is inconsistent or always changing might find the ARR model too difficult to track accurately.
People Also Ask
Why is ARR important for a subscription business?
ARR is a key metric for subscription businesses because it provides insight into the expected revenue the business can expect in a given time period. It helps give businesses an idea of how well their products and services are performing, as well as how pricing levels will affect their bottom line.
What is the difference between revenue and annual recurring revenue?
Revenue generation includes any money a company receives from customers, regardless of the billing cycle or payment terms. ARR is a specific type of revenue that only includes recurring payments made by customers on an annual basis.
What is a good recurring revenue rate?
In general, growth in net MRR of 10-20% is considered a reasonable rate. A company’s goal should be to continually increase MRR in order to grow its overall ARR.