To establish a budget, subscription-based businesses need to know how much money they can expect monthly and annually.
Based on those calculations, merchants can confidently execute business strategies and advancement plans to meet their subscribers’ needs.
The two key metrics that serve these purposes are monthly recurring revenue (MRR) and annual recurring revenue (ARR).
In this article, we’ll explain what ARR is, how it’s calculated, and how it is useful for a subscription-based businesses.
What Is ARR (Annual Recurring Revenue)?
ARR is a business metric that indicates the amount of recurring revenue made from annual subscriptions within one calendar year.
Why Is ARR Important?
Calculate ARR to precisely know how much money you can count on in the next 365 days.
Businesses can also use ARR to track their progress or stagnation over the years, identifying strong and weak points in their subscription sales.
Moreover, ARR is a valuable figure when evaluating business goals and achieved results.
Based on these calculations, business owners can change their pricing tiers and the services and products they offer to increase profit.
Likewise, ARR is a helpful metric when you want to measure the impact of a newly released product or service over a one-year period.
Note: Learn everything you need to know about monthly vs annual subscriptions for your business.
How to Calculate ARR?
The main elements for calculating ARR are pricing tiers, subscription durations, and subscription changes.
Formula for calculating ARR:
(The Total Amount of Yearly Subscriptions + Expansion Revenue) – Canceled Subscriptions (Churn Rate) = ARR
Note: ARR includes recurring revenue only. One-time payments and fees aren’t part of ARR.
ARR Calculation Example
Let’s take a new subscription business as an example. In this case, ARR is calculated by multiplying the number of annual subscribers by the annual subscription amount.
It’s important to emphasize that businesses using several tiers need to calculate ARR for each tier separately and then add those sums together, as illustrated below.
|Tier||Annual Subscription||Number of Subscribers||ARR per tier|
Some subscribers pay their subscriptions for several years in advance. In that case, divide the paid amount by the number of years. For instance, if a subscriber pays $5,000 for a five-year subscription, ARR for that client is $1,000 for each of the next five years.
For businesses that have been in operation for more than a year, the calculation is different. They need to include recurring revenue and expansion revenue (upgrades and add-on payments), and subtract the subscriptions that have been canceled since the last ARR.
ARR vs. MRR vs. ACV vs. Revenue: What’s the Difference?
When calculating a business’s total revenue, it’s important to understand the difference between the following revenue categories:
- ARR (Annual Recurring Revenue). The recurring revenue from subscriptions calculated annually.
- MRR (Monthly Recurring Revenue). The recurring revenue from subscriptions calculated monthly.
- Revenue. An accounting term referring the money generated from the essential business operations, like service and product sales, interest rates, and other relevant sources of income.
- ACV (Annual Contract Value). The normalized average revenue of one contract a customer contracts annually. Together with ARR, MRR, and the customer acquisition cost (CAC), ACV helps companies calculate how much time it takes to start making money from a customer/contract. Formula for calculating ACV:
Total Contract Value / Total Number of Years in Contract = Annual Contract Value
If a company signs a three-year contract with one business worth $18,000, the ACV for that contract is $6,000 per year. In this case, ACV and ARR are the same.
On the other hand, if a company signs five annual contracts with five different businesses - within a single pricing tier worth $100 per month, the ACV is $1200 per contract (12 months multiplied by the $100 monthly subscription amount) and the ARR for that year is $6000.
ARR helps subscription businesses identify the number of paid annual subscriptions and calculate total yearly earnings.
As such, it’s an invaluable metric for analyzing progress towards business goals and making future decisions that enhance the sales of services and products offered by subscription businesses.