What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue is an essential SaaS business metric that refers to revenue, normalized on an annual basis, that a company expects to receive from its customers for providing them with the product and services. The measure is primarily used by businesses operating on a subscription-based model.
How to calculate ARR?
To put it in the simplest form, here are some examples:
- A customer subscribes to a service for $10 a month on a one-year contract. To find the correct number, multiply the monthly cost by 12. ARR equals $120.
- Another customer subscribes for $20 a month on a two-year contract. This would be $480 for the duration of the contract, or $240 per year.
- Finally, a third customer pays $5 per month, on a month-to-month contract. The ARR would be calculated by how long they remain a customer (up to $60 per year if they remain on the contract for at least 12 months).
However, as the complexity of the subscription model increases, ARR calculations depends upon various factors:
Customer revenue per year: The basis of your ARR calculation. This is the total revenue accrued each year through annual subscriptions.
Add-on purchases: Any purchase that increases the annual subscription price on an ongoing basis.
Product upgrades: Any upgrade that increases the annual subscription price on an ongoing basis.
Product downgrades: Any downgrade that decreases the annual subscription price on an ongoing basis.
Cancellations (Churn): Account cancellations and customers lost due to churn that results in lost revenue.
ARR = (Overall Subscription Cost Per Year + Recurring Revenue From Add-ons or Upgrades) - Revenue Lost from Cancellations.
Uses of ARR: Annual recurring revenue (ARR) is considered one of the most important metrics for subscription-based companies. Some crucial applications are:
- Quantifying the company’s growth
- Evaluate the success of the business model
- Revenue forecasting