What is annual recurring revenue (ARR)? Definition and how to calculate

Imagine being able to restock your favorite brew just when you need it, or having groceries consistently delivered to your doorstep.

Subscription-based businesses cater to these desires, and they aren’t just limited to digital services such as music or movies. Physical products, services like health club memberships, and even internet connections can all fall under this business model.

In this guide, we’ll provide a comprehensive overview of annual recurring revenue (ARR) — a crucial metric that sheds light on the financial health of a software-as-a-service (SaaS) company.

What is annual recurring revenue (ARR)?

Annual recurring revenue (ARR) is the predictable yearly revenue generated from a company’s subscription-based services or products. This metric is especially valuable for businesses in the SaaS sector and other subscription models because it provides insights into long-term financial stability and customer loyalty.

Annual recurring revenue vs. revenue

While revenue encompasses all income types a business may acquire, whether recurring or one-off, ARR zeroes in on predicted future income rather than actual income. It serves as a solid barometer of business stability and proves invaluable for long-term strategic planning.

ARR specifically pertains to the predictable yearly revenue from subscription-based services, reflecting a business’s stability in terms of customer commitments. On the other hand, revenue is a broader metric that encompasses all income a company generates, including one-time sales, ad hoc services, and other non-recurring sources.

While ARR provides insights into the sustainability and predictability of income in subscription-based models, revenue gives a holistic view of the company’s total earnings.

Examples of ARR in action

Many of the primary responsibilities of a product manager — such as maintaining a foothold in the market, retaining key customers, and enhancing your business’s profit margins — hinge on ARR.

Software-as-a-service (SaaS) giants like Salesforce and Adobe deploy ARR to monitor the growth trajectory of their recurring revenue models. Other subscription-driven entities such as Spotify and Netflix leverage ARR to forecast earnings, influencing pivotal decisions around product pricing and offerings.

Additionally, ARR stands as a critical metric for cloud service providers such as AWS, GCP, and Azure when strategizing on upselling and cross-selling to nurture and diversify their enterprise.

Why is ARR important?

The significance of annual recurring revenue is implicit in its name, but here are some specific ways in which tracking ARR benefits a business:

• Gauging projected future growth — Properly leveraged, ARR can foresee a company’s prospective growth, stability, and market standing. Such a projection serves as an insightful gauge of the efficacy of a company’s prevailing strategic endeavors
• Assessing business model efficacy — Companies often employ varied subscription paradigms across their operations, and not all models are created equal. With ARR, businesses gain clarity on which models resonate with their clientele and which require fine-tuning
• Projecting revenue — ARR often sets the stage for predicting imminent sales, and it’s frequently the foundation for intricate calculations that envisage a company’s sales trajectory
• Discerning ASP tendencies — The average selling price (ASP) is indispensable for forecasting sales and pinpointing apt service fee structures. Through ARR, you can pinpoint in-demand ASP characteristics
• Retaining stellar employees — To ensure your top-tier sales professionals remain committed, turn to annual recurring revenue. Rewarding stellar performance not only reduces staff attrition but also trims the expenses related to onboarding new employees
• Attracting potential investors — For an investor, the allure of one-off sales pales in comparison to the guaranteed revenue streams of the subscription model. Businesses founded on ARR principles offer more consistent and predictable sales patterns. Such business models not only charm potential investors but also bolster the chances of sustained success

Calculating ARR

Gaining a clear understanding of annual recurring revenue (ARR) requires a look into the revenue trends of your company. This includes insights from new customers, renewing clientele, incremental boosts from add-ons and upgrades, and the downsides of downgrades, customer losses, and revenue churn.

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To calculate ARR, take into account the following metrics, each of which directly influences the final ARR value:

• Annual revenue per customer
• Revenue through product add-ons and upgrades
• Lost revenue due to downgrades
• Lost revenue stemming from customer churn

Here’s a straightforward formula to represent the calculation:

ARR = (Annual revenue from subscriptions + Annual revenue from add-ons and upgrades) – (Revenue lost through cancellations and downgrades)

Crucial considerations for calculating ARR:

• Leave out one-time charges, such as setup and activation fees, non-recurring add-ons, credit adjustments, and late payment fee.
• For subscriptions that don’t adhere to a 12-month norm, like a 15-month subscription, it’s vital to define ARR within your organization tailored to your unique subscription term
• Billing cycles don’t sway ARR as long as the subscription extends for a year or more and you maintain uniform records, regardless of payment arrangements

MRR vs. ARR

Monthly recurring revenue (MRR) is distinct from annual recurring revenue (ARR) primarily in its periodicity; it’s gauged on a monthly basis whereas ARR is measured yearly. So while both ARR and MRR are revenue metrics, they cater to different timeframes.

ARR offers a macro perspective on the long-term health and investment prospects of a company. In contrast, monthly recurring revenue gives insights into the ebb and flow of seasonal revenues and the direct repercussions of organizational strategies.

The B2B subscription domain, where contracts often stretch for 12 months or beyond, frequently relies on ARR. On the flip side, B2C subscription businesses, where the minimal service tenure is billed monthly, utilize MRR. Examples of this include platforms like YouTube Premium and GrubHub+.

For those whose pricing strategies revolve around MRR, the transition to ARR is straightforward.

Calculate MRR using the following formula:

MRR = Starting MRR for the month + New client MRR for the month + MRR from monthly customer upgrades – MRR lost from customer downgrades in the month – Total monthly MRR churn

To project ARR from MRR:

ARR = MRR x 12

How is ARR related to customer retention, churn, and expansion?

The dynamics of customer retention, churn, and expansion play a pivotal role in shaping a company’s annual recurring revenue (ARR). Here’s a closer look at these intertwined relationships:

• Customer retention
• Churn
• Expansion

Customer retention

Customer retention refers to the ability of a company to hold onto its existing customers for a set duration. It’s usually denoted as a percentage, and can be deduced using this formula:

Customer retention = (# of customers at the end of a period – # of new customers acquired during that period) / # of customers at the start of the period

A high customer retention rate is directly linked to a growing ARR. As customers continue their subscriptions for services or products, the ARR prospers. Elevated retention ensures a more stable and foreseeable revenue stream.

Churn

Churn quantifies the customers who terminate their subscriptions or memberships within a given time frame. It is depicted as a percentage and can be calculated with the following formula:

Churn = # of customers lost during a period /# of customers at the beginning of the period

Churn inherently affects ARR. As customers cease their subscriptions, the ARR diminishes. Hence, curbing churn is paramount to sustaining and augmenting ARR.

Expansion

Expansion encapsulates the additional revenue derived from existing customers, beyond their initial subscription outlay. This might stem from upsells, cross-sells, or additional features or bundles. As existing customers gravitate towards augmentations or added offerings, the value of their subscription and, subsequently, the ARR ascends.

In summary:

1. An elevated customer retention rate paves the way for a more robust and expansive ARR
2. Elevated churn rates dent the ARR, as departing customers whittle down the subscription-based income
3. Successful growth blueprints that amplify earnings from extant customers typically culminate in an upsurge in ARR

Leveraging ARR, enterprises can pinpoint their premium customers and endeavor to retain them. Concurrently, they can discern potential churn candidates and institute preventive measures. Beyond its predictive capabilities for future revenues, ARR facilitates the ideation of innovative monetization strategies for the present clientele.

3 examples of ARR-fueled growth

Companies can use ARR to identify their most valuable customers and focus on keeping them. They can also identify which clients are considering quitting and take appropriate action.

ARR not only assists businesses in predicting future profits but also in identifying new ways to charge current customers. Here are three real-world cases of well-known SaaS companies that have used ARR to fuel their growth:

1. HubSpot
2. Netflix
3. Zoom

1. HubSpot

A quintessential example of ARR-driven growth, HubSpot’s evolution as a marketing and sales behemoth is noteworthy.

With an accentuated focus on ARR, HubSpot amplified its annual recurring revenue by more than 20 percent year-on-year. This growth trajectory was achieved through a judicious mix of pricing strategy refinement and steadfast commitment to customer retention and expansion.

2. Netflix

The stratospheric rise of Netflix’s ARR can be attributed to its burgeoning streaming service footprint. A calculated investment in original content, coupled with bespoke user recommendations and a widened global expanse, has been its success mantra.

Netflix has perpetually amplified its ARR by upholding a competitive pricing ethos and staying a step ahead of industry rivals.

3. Zoom

The COVID-19 epoch saw Zoom metamorphose into a ubiquitous video conferencing solution.

Seizing the emergent demand for distanced collaboration, Zoom experienced an upswing in user onboarding. Offering a gratuitous plan for brief engagements and judiciously priced premium tiers for corporate entities, Zoom witnessed a meteoric rise in its monthly recurring revenue.

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9 best practices for optimizing ARR

ARR is an essential metric for businesses, especially in the subscription-based sector. To maximize your ARR, here are nine best practices you should consider:

1. Customer acquisition and retention — Balance the act of attracting new customers with retaining existing ones. Discounts and special offers can allure new customers, while exceptional support and loyalty programs can enhance retention
2. Subscription upgrades and add-ons — Utilize upselling and cross-selling to encourage customers to opt for higher-tier plans or additional services
3. Pricing strategy review — Regularly evaluate your pricing model to ensure alignment with customer value and market dynamics. Tiered pricing may allow you to cater to various customer segments, and staying in tune with competitors’ pricing helps maintain competitiveness
4. Churn reduction — Attrition can be detrimental to ARR. Investigate churn causes and act proactively to mitigate them through enhanced product quality and customer experience improvements
5. Trial conversion — If offering free trials, concentrate on converting trial users into paying customers by offering a smooth onboarding experience and articulating the product’s value
6. Yearly plans and prepayments — Incentivize customers to commit to longer subscriptions by offering discounts for annual plans or prepayments
7. Explore new markets — Identify and market to unexplored segments within your target audience that could derive value from your products or services
8. Continual product development — Incorporate customer feedback and suggestions into ongoing product development, including regular feature enhancements and bug fixes
9. Strategic partnerships — Forge alliances or collaborations with other organizations to amplify your reach and access new customer segments

Key takeaways

Optimizing ARR is an intricate and unending process, necessitating keen observation, comprehensive analysis, and strategic iterations. The dynamic nature of markets and customer preferences demands continuous adaptation and innovation from businesses today.

Key takeaways for enhancing ARR include:

• Embrace both acquisition and retention — Both new and existing customers hold value, and a balanced approach can maximize ARR growth.
• Be agile with pricing — Regular reviews and adjustments can keep your pricing in sync with market demands.
• Mitigate churn proactively — Addressing the root causes of customer attrition can stabilize and grow your revenue base.
• Leverage partnerships and feedback — Collaboration with other businesses and responsiveness to customer feedback can foster growth and continual improvement.

Fostering a culture of learning, innovation, and market responsiveness enables organizations to not only increase the effectiveness and profitability of their efforts but also position themselves for long-term success in the evolving subscription economy.

Featured image source: IconScout