Regular assessment of the business’s health is essential to ensure its growth and sustainability. Early detection of possible negative trends will allow you to correct them easily. Likewise, signs of success need to be supported and developed.
One of the most popular metrics for assessing the performance of subscription companies is annual recurring revenue (ARR). To give your business the right direction, you need to learn how to calculate this metric. Including any additional variables in its formula or ignoring the basic ones will distort your understanding of the current state of affairs. Therefore, you should stick to the formula that has been tested in many cases.
Meaning of Annual Recurring Revenue (ARR) for SaaS Companies
ARR meaning is quite clear: it is the recurring revenue a business receives from consumers during the year. Analysts use two closely related metrics to measure a company’s revenue from contacts, subscriptions, and other recurring revenue:
- ARR ― annual recurring revenue;
- MRR ― monthly recurring revenue;
They differ only in the period you want to measure and compare.
The Value of ARR Metrics for Business Performance Assessment
With the help of ARR/MRR, you can conduct a comprehensive analysis of the health of your business:
- Evaluate current financial standing;
- Forecast expected profit;
- Assess progress toward yearly growth goals;
- Analyze the history of business development in dynamics.
Ultimately, all this is necessary to optimize the business and give it impetus for development in the most promising direction.
Benefits of Calculating ARR Metrics
- Businessmen can evaluate the impact of their decisions on the company’s profit. This could be decisions related to expanding the range of services, adding new features, rebranding the company, entering new markets, etc.
- ARR works well in combination with other metrics, allowing you to form a more objective picture of the business success or failure factors. Among other important indicators, analysts take into account churn percentages, changes in pricing, downgrades, and others.
- Analyzing ARR helps businessmen make more informed decisions that will have a positive impact on their business.
This way, you can make more realistic plans for the future and consider the most promising opportunities offered by your business model.
- ARR shows the effectiveness of the subscription business model in relation to the services you provide. If its values are far from what you are aiming for, you may consider other pricing approaches.
How to Calculate ARR Correctly?
ARR reflects the entire subscription revenue earned for the year minus the revenue lost from subscription cancellations and downgrades. Expressing this idea more precisely in a formula, you get the following:
ARR = (Total subscription revenue for the year + recurring revenue from upgrades and add-ons offered by a company) – revenue lost from downgrades or complete cancellations of subscriptions by certain customers
Please note that the formula takes into account only recurring revenue, not one-time payments. That is, upgrades and add-ons are included in the formula if they affect the cost of services for subscribers.
If you regularly calculate MRR, you can simply multiply this indicator by 12.
Four Variables That Should Be Included Into the Formula
So, your formula can have only the following four components:
- The total revenue you get from annual subscriptions and renewals.
- New features and account upgrades that increase the cost of an annual subscription.
- Any downgrades that result in a loss of revenue. This could be a narrowing of the range of services or product features that make the subscription cheaper. This also takes into account the decrease in revenue from customers who switched to a cheaper subscription plan.
- Irrecoverable losses from customer churn. You should include only the actual churn of customers. If a customer’s subscription is still active, but they simply canceled it, this is not yet an irrecoverable loss of revenue. Some of the lost revenue can still be recovered with the help of a competent marketing strategy.
What Variables Should Be Excluded from the Formula
Don’t include “non-recurring” aspects of your revenue model in the ARR formula. Its name “Annual Recurring Revenue” clearly outlines what it should analyze. Among such elements that can be mistakenly added to the calculations are the following:
- Set-up fees, which are associated with the consumer’s first payment;
- One-time charges;
- Add-ons, which do not increase the cost of a subscription;
- Modifications in the cost of services due to credit adjustments.
Effective Ways to Optimize ARR
Generating recurring revenues provides businesses with financial stability and sound prospects for further growth. Measuring and evaluating the ARR indicator is necessary to identify the strengths and weaknesses in your business decisions.
Here are some ways you can increase your revenues and, as a result, annual recurring revenue:
- Review your customer acquisition strategy. You should achieve an increase in the new consumer base while minimizing customer acquisition costs.
- Try to get more money from current subscribers by offering them promising upgrades and optimizing your value metric.
- Put additional effort into retaining customers. For example, these can be profitable loyalty programs or more diversified tariff plans that take into account the interests of customers.
- Analyze your customer acquisition costs and find less expensive methods. These costs are not included in ARR or MRR, but reducing them will allow you to spend your company’s money more efficiently.
Should You Calculate ARR and MRR?
MRR is a more sensitive metric. It allows assessing the impact of the slightest changes in your company’s operations on your recurring revenue.
But for creating long-term plans and strategies, you need a different scale of assessment. In this case, ARR acts as a more reliable foundation since it neutralizes insignificant monthly fluctuations in MRR. Therefore, to make grounded short-term and long-term decisions, you will need both of these indicators.
The Bottom Line
The ARR indicator objectively depicts the health of your business and its ability to grow. Identifying its fluctuations will highlight effective decisions or, on the contrary, counterproductive ones. Based on this knowledge, you will be able to get the most out of your subscription revenue model. Therefore, all your investments of time, effort, and resources will give the maximum increase in profit.