Annual Recurring Revenue (ARR) is a key metric that shows you how much recurring revenue to expect within a year. Businesses that operate on a subscription-based model are most likely to benefit from ARR calculations. If you are familiar with monthly recurring revenue (MRR), ARR is the annualized version of this measurement
What Does Annual Recurring Revenue “ARR” Mean?
Annual Recurring Revenue, or ARR, is a subscription performance metric that shows the revenue anticipated every year over the life of a subscription or contract.
In other words, Annual Recurring Revenue represents the anticipated, annualized revenue from a company’s current subscriptions and contracts. Revenue that is not contractually obligated to the company, such as service fees, is not counted in this metric.
With that in mind, ARR can be used to measure the health of a subscription-based business, such as a Software as a Service company, by measuring the revenue on which the company can rely over the course of the year.
Additionally, Annual Recurring Revenue can be helpful as a relationship measurement tool. Since subscription commitments can indicate the relationship customers have with your product, their willingness to agree to an ongoing relationship may be an indicator of their confidence in your brand or satisfaction with your brand.
Conversely, a high number of customers who prefer non-contractual interactions may indicate that they require an additional “nudge” to commit to your service financially.
The formula for ARR is:
ARR = (Subscription Cost Per Year + Recurring Revenue From Upsells and Upgrades) – Revenue Lost from Cancellations or Churn.
Who Should Use the Annual Recurring Revenue Model?
The ARR model of determining ongoing revenue is best suited to companies that sign most customers to a term of at least one full year.
Businesses that offer monthly subscriptions can also estimate annual recurring revenue by projecting each customer’s monthly charges out to one year. But because customers can end their subscriptions at the end of any month, these businesses will find the ARR model less accurate. Companies offering monthly subscriptions should instead use a monthly recurring revenue (MRR) model.
How Do You Calculate Annual Recurring Revenue?
To calculate your annual recurring revenue, you will first need to calculate three figures:
- The total dollar amount of annual subscriptions.
- The total dollar amount of additional ongoing revenue (training, installation, support, etc.).
- Total dollar amount lost through subscription cancellations (customer churn).
The formula looks like this:
Annual subscriptions + additional ongoing revenue – cancellations (3) = ARR.
If you sell your product via a monthly subscription model, you can use a similar formula to the one above, then multiply the monthly number by 12.
Why does ARR matter for a subscription model business?
- When you provide a subscription-based product or service, ARR tells you your annual basis revenue based on what you expect to receive from your customers
- ARR is a metric that helps you better understand your company’s growth
- By evaluating your subscription model using ARR, you can better forecast expected revenue
- When you break down Annual Recurring Revenue into components such as ARR from upgrades and ARR from new customers, you better understand what factors are contributing the most to your revenue
How does ARR differ from MRR?
While Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are similar metrics, they cover different time periods (a year vs. a month).
ARR offers insight into your company’s recurring revenue on a macro scale, compared to MRR, which is calculated on a micro-scale. Therefore, ARR offers greater long-term insight, which is critical for both your company’s management and investment opportunities.
- ARR is most beneficial for viewing year-over-year financials to improve planning.
- MRR allows you to dive deeper, so you can see the immediate effects of any changes or developing strategies. It also allows you to view revenue fluctuations at different times of the year.
Why should you calculate both?
Insights into your company’s health can be gained from looking at both ARR and MRR. If you know how much revenue your firm will generate as it expands, you may make strategic decisions about how to spend it judiciously.
To plan for long-term product development and create corporate roadmaps, especially for SaaS companies, ARR provides a high-level view of year-over-year growth.
Using MRR, you can see the company’s growth in more detail. Using this method, it is possible to see how changes in product or pricing strategy affect renewals immediately. It’s also a technique to keep track of seasonal variations in client behavior.
By combining the two, you can better plan your strategy and track your progress each month. This larger pool of knowledge enables you to make faster and better decisions, resulting in a better overall client experience.
Why is ARR Important?
As mentioned, early-stage businesses typically think in terms of MRR vs. ARR. That being said, you shouldn’t lose sight of measuring ARR.
MRR may provide a quick snapshot of short-term growth, but ARR can paint a bigger picture. With ARR, you can use these metrics for long-term planning, company road mapping, and financial modeling.
As you grow, ARR will be a great benchmark for you to show investors and other stakeholders the impact you have made in the market and how your growth has compounded over time. Some larger businesses also use ARR as a measure of overall business health and performance.
Is ARR higher than revenue?
When calculating Annual Recurring Revenue, we would not typically expect the total to be higher than revenue, overall. This is because the revenue considered in ARR is specifically subscription or contract-based.
Other revenue, such as one-time purchases and late fees, are not considered in Annual Recurring Revenue – though they are still important to consider from a profit and loss standpoint.
With that in mind, when calculating Annual Recurring Revenue, we would expect to find a lower dollar figure than that of overall company revenue.