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A key metric for subscription-based companies is Annual Recurring Revenue. But what does it mean, and why is it important?
What is Annual Recurring Revenue (ARR)?
ARR is the annual revenue generated from subscription customers. This metric allows companies to accurately forecast their future operating revenueand strategize accordingly.
It is useful in quantifying the success of a given product or service because of its transparency.
An ARR model can reduce the noise around a given product or service and allow it to be evaluated by numbers alone.
Also, ARR enables easier comparisons between companies within the same industry,
Understanding Annual Recurring Revenue (ARR)
Subscribers with contracts of multiple years are worth a certain amount per year in subscription fees, not including one-time fees.
While the pay structure may vary, subscription-based businesses can use ARR for those long-term contracts to report revenues in terms of one-year increments.
In the past, companies such as Microsoft might offer software such as Microsoft Office on disc in one-time payments of around $150 for a lower-tier software package.
Annual budget planning is more difficult when purchases spike at different points through the year, such as the start of the school or fiscal year.
With SaaS services like Microsoft 365, which is completely cloud-based, the customers are now charged on a subscription model, sometimes for multi-year contracts in the case of corporate customers.
These multi-year contracts allow a company like Microsoft to report revenues in terms of ARR.
This, in turn, provides managers with relatively reliable revenue streams that allow for better budget planning, especially as more long-term contracts are added to the books.
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How to Calculate ARR
Just as subscription-based business models are relatively new, so too is ARR. For that reason, it can be defined in several different ways.
However, the more accurate this figure can be, the better a company can conduct budget planning.
For the best results, the following revenue figures should be considered when calculating Total ARR:
- ARR from new contracts and sales
- ARR from renewed contracts and sales
- Increases in revenue from existing customers who add on services
While adding the figures above is a good start, accurate Total ARR must account for reductions in revenue such as:
- Decreases in revenue from customers removing services
- Revenue Churn
For both additions and reductions, the ARR is calculated very simply by dividing the values of each bullet point above by the number of years, then adding (or subtracting) the value from each bullet point together.
Let’s look at a quick example for a company specializing in 5-year SaaS contracts. We’ll use the same bullet points above.
- 2021 New sales: $50,000 / $10,000 per year
- 2021 Renewals: $250,000 / $25,000 per year
- 2021 Add-ons: $15,000 / $3,000 per year
- Non-renewed contract: ($10,000) / $2,000 per year
- Reduction of Service: ($2,500) / $500 per year
Assuming all of these contracts are five years, you simply add up the figures from the last part of each line for a Total ARR of $39,500.
It’s also important to note that ARR does not include one-time sales. Some industries might call these “spot” sales, and they are seen as short-term sales.
While they are good for boosting short-term revenues, they are not “recurring” by definition, so they cannot be included.
Industries that Use ARR
As mentioned previously, AAR is very popular among businesses that offer their services on subscription models or business models where the primary revenues come from long-term contracts.
While we have been focusing on companies offering SaaS, such as Microsoft (MSFT) and Salesforce (CRM), AAR could be a beneficial tool for a company like Birchbox that sells product packages monthly, also known as subscription boxes.
Some real estate companies that focus on renting office space in multi-year contracts can also benefit from calculating ARR.
Residential real estate rental is a bit different since most lease agreements max out around one year.
Those companies might focus on another metric, like Monthly Recurring Revenue (MRR), to plan their budgets.
Annual Recurring Revenue FAQs
How is ARR defined?
ARR is very simply a metric that provides companies with the revenue of a particular contract split up in one-year increments. Instead of considering the whole contract’s value as part of a lump sum in the year, it was started, the value can be split up for each year the contract is expected to last.
How is ARR calculated?
ARR is calculated by taking all new contracts, renewed contracts, and customer add-ons and dividing those figures by the number of years the contract is to last.
You should also add up the lost contracts (churn) and reduced services, divide those by the number of years of the expected contract, and then subtract from the first figure.
There is some variability in calculating lost contracts or churn because it really depends on how a company defines that figure.
If the contract was expected to be renewed by the customer but wasn’t, the service provider could calculate it as one year of lost revenue or lost revenue for the same number of years that the original contract was to last.
What is the difference between ARR and revenue?
ARR only takes into account that revenue which is recurring based on long-term contracts. Total revenue takes into account revenues from all sources of a business, including one-time sales.
What is the difference between CARR and ARR?
CARR is committed annual recurring revenue. This is a bit different as it considers those contracts that are – with a relative level of certainty – going to expire without being renewed. On the flip side, it could also include business that will be part of ARR but has not quite been confirmed as a signed contract.
Bottom Line: Annual Recurring Revenue (ARR)
ARR is an excellent way for companies to level out the charts of their annual revenues and plan for budgets a bit better.
This is a much better way to run a subscription-based business than previous methods with spikes in revenues and, potentially, long periods of reduced revenue.