How To Calculate Annual Recurring Revenue (ARR).
Mar 7, 2024
‘If you cannot measure it, you cannot improve it’. Learn how to calculate annual recurring revenue so you can make the right decisions to grow it.
Subscription businesses are highly sought after due to their capacity to generate recurring revenue. Yet, it’s possible to operate a ‘recurring revenue’ company without a significant portion of your revenue actually recurring over a reasonable period.
Hence, relying solely on a monthly recurring revenue value may not provide an accurate assessment of a subscription business's growth or financial efficiency. Especially when considering that it takes three months on average to make a profit from a new subscriber. If a customer churns after just one month, you can’t say you have made any money.
Therefore, failing to accurately determine the portion of your annual revenue that is recurring can be costly when operating a subscription or other recurring revenue business. In essence, knowing how to calculate annual recurring revenue correctly is crucial.
What is annual recurring revenue ARR?
Annual recurring revenue(ARR) is the total revenue generated in a year from customers who have committed to a yearly subscription or contract. ARR is essentially an annualised version of monthly recurring revenue (MRR).
Tracking ARR is crucial for businesses operating on a recurring revenue model as it provides insight into the expected annual revenue from customers.
You can also define recurring revenue as fees or payments a customer has committed to pay annually. This can be subscription fees, membership fees, equipment rentals, or licence fees.
Why is it important to know your ARR?
ARR serves as a vital indicator of a business's overall health and is instrumental in forecasting sales and future growth. . Additionally, Investors use it to measure your business’s financial efficiency and the extent to which customers have embraced your value proposition.
For example, the churn rate doesn’t tell much if you don’t factor in the ARR. A supposedly high churn rate isn’t a cause for concern if the ARR is correspondingly high. Thus , the ARR adds context to other subscription business metrics.
As a business owner, having the ability to accurately forecast your earnings for the next year enables you to plan with greater confidence. The ARR indicates the rate at which your business is expanding and the extent to which you can finance additional growth using your generated revenue.
By looking at your ARR, you can review the impact of your decisions year-over-year. You can see which strategies have moved the needle and which haven’t, giving you the insight to carve a more efficient path forward.
An accurate ARR is also essential for setting realistic goals. The best business decisions consider the revenue the business is generating and the revenue projected for the foreseeable future.
For instance , if ARR shows static growth, you have less money to invest in new customer acquisition. You may prioritise upselling existing customers as it’s cheaper than acquiring new ones.
How to calculate annual recurring revenue.
ARR serves as an indicator of your business's health, but its accuracy depends on proper measurement. Miscalculating your ARR paints a misleading picture of your business’s health or future.
Put plainly, ARR sums up the annual income from customers’ yearly subscriptions, membership fees, licence fees, or other recurring revenue. However, the calculation of ARR entails more than that.
To obtain the correct ARR and gain an accurate insight into your revenue performance, it's essential to know what should be included and excluded from the ARR calculation.
ARR calculation formula
To get accurate annual recurring revenue value, your ARR formula must account for these three things:
Recurring revenue for the year
Revenue from upgrades and addons,
Value of revenue lost to cancellations and downgrades that year.
Here’s what that might look like:
ARR = Recurring revenue for the year + the value of addons and upgrades—the value of cancelled subscriptions and downgrades.
With actual numbers, that will look like this:
ARR = Ksh30,000,000 + 6,000,000 - 7,000,000
= Ksh 29,000,000.
The annual recurring revenue, in this case, works out to Ksh 29 million.
Your recurring revenue for the year is generated from customers who maintained their subscriptions and ideally have already renewed them.
Revenue from upgrades and add-ons represents the extra or expansion revenue from customers who upgraded or added a feature or benefit to their original plan during the year. This is arguably the best way to grow subscription revenue.
Cancellations and downgrades account for revenue lost when customers downgraded to a lower tier/plan or cancelled their subscriptions at some point during the year.
Cancellations and downgrades decrease your revenue and point to a weak product market fit or a value proposition that promises more than what the product delivers.
What to exclude from annual recurring revenue.
Revenue from add-ons should be what customers commit to paying on top of their regular subscription going forward. It should not include one-time charges like installation and other service fees.
Those will inflate and give an inaccurate picture of your ARR.
ARR should be a sum of yearly recurring charges for paying customers. That revenue should be recurring or generated in the same amounts throughout the year.
Let’s use the example of a customer on a Ksh 2,000 per month SaaS subscription. Their ARR is not Ksh 24,000 (Ksh 2,000 times 12 months) if they downgraded to a Ksh 1,000 per month plan for the last two months.
Their yearly recurring revenue is Ksh 22,000 because they did not maintain their subscription for two of the 12 months. What they paid for the year is Ksh 22,000, not Ksh 24,000. The Ksh 24,000 is not wholly recurring.
The calculation will be like this:
ARR = Ksh 24,000 (12xKsh 2,000) - Ksh 2,000 (2xKsh 1,000)
= Ksh 22,000
The Ksh 2,000 deducted above represents the MRR churn. It is value lost in the two months the customer had downgraded from a higher-value subscription plan.
What if you use a multi-year billing cycle?
If you use an annual or 36-month billing cycle, you may not have to worry about downgrades because the customer will have paid in advance for the whole year. However, you will have to add upgrades if there are any.
In this case, your ARR calculation will be like this:
ARR = Ksh 72,000/3
= Ksh 24,000
ARR will be higher if upgrades are made during the year under review. Moving from a lower-value tier to a higher-value one increases recurring revenue.
How to maximise your Annual Recurring Revenue with subscription management.
There are two main ways to grow your recurring revenue. You can acquire new customers or get your existing customers to spend more.
The latter is cheaper and more sustainable because the customer is already familiar with your product. This strategy ‘expands’ your revenue, hence the term ‘expansionary revenue’.
You can get your customers to spend more by upselling them on advanced features, such as add-ons or features on a higher plan. Of course, you must ensure you retain those customers first.
Above all, though, the most effective way to compound any ARR gains you may have is to improve your billing and subscription management. Certain customers churn not because of poor product quality but due to inefficient billing systems resulting in overcharges, delayed shipping, and service disruptions.
By automating your billing and subscription management, you make it easy for customers to upgrade, relieving them of the burden of manually paying their subscriptions each month.
If a payment fails to process because the customer changed their payment details, your subscription management software automatically sends them a reminder to update their payment details. This prevents involuntary churn and helps maintain your ARR.
Intasend provides the best automatic billing and subscription management software in the Kenyan market. Book a demo to explore our software’s features.