What Is ARR?
What is annual recurring revenue, and how can you improve yours? Read our guide to learn what you need to know about ARR.
What is ARR?
Aside from the sound that a pirate makes, ARR is annual recurring revenue.
If you run a subscription-based company, ARR is undoubtedly one of the biggest priorities for the business. But what is ARR, and how can it benefit your company? When calculated correctly, ARR is a great way to measure the financial health of your organization and predict future business. Even better, the formula to calculate ARR is easy, quick and clear. Here, we’ll break down everything you need to know to get started.
What is Annual Recurring Revenue (ARR)?
Annual recurring revenue is a way to measure the recurring revenue a company expects to earn on an annual basis. It’s a good metric for companies that offer subscription-based products or services. The model helps shed insight into factors like customer retention rate and churn rate, along with measuring the overall growth of a company. Combining information around ARR and other stats, like churn, can lead to other calculations like customer lifetime value and other important ways to view the financial reporting of a business.
Why is ARR Important for Businesses?
ARR is important in that it helps a company predict how stable a company is with its revenue. Rather than measuring revenue from just one-time big transactions, it reflects a business’s growth over a set period of time and predicts future revenue streams.
In addition, ARR helps companies make more financially-sound decisions when it comes to their sales, marketing, and product or service offerings. Decision-makers can focus more effort on what works and eliminate areas that are not bringing the company financial growth or leading to loss of customers or downgrades with the product or service. Additionally, if you understand how much a customer will bring in over the course of a year and about how long they typically stay with the company, you can get a sense of how much you can spend to acquire new customers.
Annual Recurring Revenue Formula
Fortunately, the formula for determining ARR is quick and easy. The most important thing to remember is that only recurring revenue should be calculated. Factors like one-time fees such as sign-up charges or installation charges should be excluded. Secondly, ARR should only be calculated for consistent streams of revenue. If your organization experiences common fluctuations in revenue on a month-by-month basis, consider looking into other formulas.
The formula for ARR looks like this:
Annual Recurring Revenue = Average Monthly Revenue x 12 (Months in a year)
Pretty straightforward right?
How to Calculate ARR
First up is calculating your average monthly revenue. To do this, you will multiply the number of subscribers you have by the amount they pay every month for your subscription services.
Let’s say you have 5,000 subscribers paying $50 a month.
5,000 x 50 = 250,000
Your average monthly revenue would be $250,000. Now, you will multiply your average monthly revenue by 12, which accounts for 12 months in a year.
250,000 x 12 = 3,000,000
Your ARR is $3,000,000.
What Are Examples of Recurring Revenue?
There are many pricing and billing models that lend themselves to recurring revenue. Here are some common examples:
- Monthly/Annual Contracts: Companies that offer monthly or annual fixed-term contracts for their products or services. Think of monthly phone plans that offer one-year contracts with a monthly payment.
- Automatic Renewal Subscriptions: Subscriptions that automatically renew at the end of each billing period. Some of the most popular include streaming services, gym memberships or software as a service (SaaS).
- Sunk Money Consumables: A subscription for a product or service that requires further purchases or upgrades for continued use. For example, coffee machines that require the purchase of coffee pods or a printer with an ongoing cartridge order every quarter.
- Licenses and Royalties: Businesses that license a product or intellectual property. This could include patents, trademarks, or copyrighted products, where companies receive revenue in the form of licensing fees or royalties.
- Retainer Agreements: Both individuals or organizations that can generate guaranteed revenue by providing retainers. These could include freelancers, lawyers, or consultants.
What is the Difference Between ARR and Revenue?
It can be easy to mix up ARR and revenue – but there is a difference. Revenue refers to all income that a business earns, including things like one-time transactions, licensing fees or royalties. The income also doesn’t have to be recurring, unlike ARR, which is always measured based on recurring revenue. Still, measuring overall revenue is important for evaluating the financial health of your organization to understand how one-time charges compare to the ongoing subscription-based charges.
What is ACR vs. ARR?
Another common question is the difference between ARR and ACR, or annual contracted revenue. ACR measures the amount of revenue coming from all types of contracts over a year, including those that are both one-time or recurring. ARR, on the other hand, is more specific, just measuring recurring revenue from subscriptions or subscription renewals.
Common Mistakes Made When Interpreting ARR
Though the ARR formula and calculation method may be simple, there is still the possibility of making mistakes when looking over the data. Check out the following errors businesses make so you can avoid them:
- Including Those One-Time Fees
No type of one-time fee should be included, even if it comes from a long-time, loyal client or is a small amount. Only include those recurring payments. This leads to inaccurate financial information, which is important to avoid for businesses.
- Assuming ARR Represents Exact Revenue
Remember, ARR is the predicted amount of revenue your company expects to receive in a year. It is rarely the exact amount you will actually get.
- Not Considering Potential Revenue Upgrades
Don’t forget about the possibility of upgrades, upsells, or cross-sells. While these should not be calculated as part of the formula, it could lead to an underestimation of your revenue.
- Overlooking Churn Rate
On the other end of the spectrum is the churn rate, or the amount of customers that choose not to renew their subscription or contract with your company. Overlooking churn rate can lead to an overestimation of your revenue.
- Forgetting About Discounts, Promotions, or Free Trials
Forgetting things like seasonal discounts, promotions, or free trials for your products or services can lead to misinterpretation of the data.
- Relying Just on ARR for Financial Decisions-Making
Yes, ARR is a great metric to consider when analyzing the financial health of your business. However, it shouldn’t be the only metric you use. You should also consider financial formulas and calculations like profitability, cash flow, accounts payable and receivable, churn rate and lifetime value.
How to Improve Annual Recurring Revenue
Once you have your ARR calculated and data laid out, the question becomes: how can you make it even better? Luckily, there are a few tips and tricks you can implement:
Improve Customer Acquisition
The biggest way to boost your ARR? Acquire more customers. Luckily, there are plenty of ways you can do this, including:
- Refining your marketing through more targeted campaigns
- Going after new user personas
- Offering sign-up incentives or free trials
- Implementing referral programs
Reduce Customer Churn
If you find that your business is suffering from a high churn rate, you’ll want to focus on improving customer retention. To accomplish this, you can:
- Provide an enhanced user experience
- Offer greater customer support
- Engage with customers and ask for feedback
- Expand your offering to offer a wider range of services
Assess Your Pricing
Does the pricing for your product or service match what’s currently on the market? Consider areas where you can up-sell or cross-sell with higher-tier plans, packaging options or even pricing models. A mixture of one-time fees and subscription-based pricing could improve the revenue mix.
Focus on the Renewal Process
No user wants to face a long, complicated process to renew their subscription. At that point, they may just give up. Focus on creating a renewal process that makes signing up easy and done in just a few steps. You can also send reminders and incentives for timely renewals. If your service has the capability, including an auto-renewal clause in your agreements helps get ahead of the discussion with an implied buy-in going forward.
Improve Your Product or Service
Of course, the big one is to continue improving upon your product or service. That means experimenting with new features, add-ons, and quality. This is where customer feedback is essential – what do your loyal customers think could be better? Are there additional services that would warrant customers paying more? Make them happier, and you can enjoy an even higher ARR.
Improving your ARR will take time, patience, and lots of experimenting. However, it shouldn’t have to be a painful process. With the right support along the way, you can concentrate on making your financial health even stronger and more successful than ever before. For example, Decimal can help you remain steady with your financial health by taking care of your accounting, bookkeeping and payroll needs – taking care of the little details while you take care of the big ones. Get in touch today!
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