What is Annual Recurring Revenue?

For the subscription economy, make no mistake: annual recurring revenue is a highly useful metric to keep tabs on. Annual recurring revenue can provide a high-level view of the health of a business, as well as the requisite information needed for accurate forecasting. In this article, we’ll define ARR, explain how to calculate ARR, and identify why subscription businesses value ARR. 

What is Annual Recurring Revenue (ARR)?

Annual Recurring Revenue, or ARR, is a metric used by the subscription economy which represents the value of subscription contracts normalized to a full calendar year. Put another way, ARR is the repeat revenue a business firm can expect to receive for a subscription on an annual basis. 

For example, if a client signs on for a subscription for three year’s worth of software access for $24,750 over the life of the contract, the provider’s annual recurring revenue on that account would be equal to $8,250 for each calendar year ($24,750 ÷ 3 years). The $8,250 is a predictable stream of revenue that can be relied upon each of the three years. 

With this in mind, as a subscription business adds more and more clients, they can forecast growth over multiple years building on the guarantee of repeat revenue before even projecting revenue from prospective clients. 

How to Calculate Annual Recurring Revenue

While our three-year subscription above provides an easy-to-follow example of annual recurring revenue, the reality is that the calculation often isn’t quite that simple. When calculating annual recurring revenue, there are three main variables that need to be taken into account. These include:

1. Total dollar amount of yearly subscriptions: The total dollar value a subscription business will earn from current, new and renewing customer subscriptions.
2. Total dollar amount of recurring upgrades and add-ons: The total dollar value of upgrades made by current customers. For example, if a cloud storage provider has a client who during certain times of the year requires additional storage, the up-charge, if it is recurring and not a one-time fee, also factors into ARR in addition to the value of the subscription’s base cost. 
3. Losses from downgrades and departing customers (churn): The total dollar value a subscription business will lose on expiring subscriptions or downgrades to service or product suite. If a client declines to renew a subscription, the ARR of that account must be subtracted from overall ARR. 

Note that one-time charges or non-subscription fees should not be included in the calculation of ARR as they could vary or not even exist one year to the next. One example of this would be a setup or on-boarding fee. As businesses can typically only charge a setup fee once, it would not be a recurring transaction. ARR strictly tracks fixed charges and fees as they are guaranteed at intervals over the life of the subscription. 

Billing structures typically do not affect ARR so long as revenue is produced yearly. If a customer signs a contract for a three-year subscription worth $15,000, the ARR would be $5,000 regardless if it is paid in yearly, quarterly or monthly installments. The underlying principle is that the business can expect to bring in $5,000 in revenue per year as the value of the contract does not change after a contract is agreed upon, unless of course the client purchases upgrades or downgrades the subscription. 

Factoring upgrades or downgrades into the equation, let us create another example from our $15,000 ARR account above. Let us say that a client plans to purchase a $1,500 upgrade in years two and three of the subscription. The ARR would then grow from $5,000 to $6,000 per year ($15,000 + 2*$1,500 = $18,000. $18,000 ÷ 3 = $6,000). On the other hand, if the same account were to downgrade service at a savings of $1,000 per year in years two and three, the ARR would then be $4,333.33 ($15,000 – 2*$1,000 = $13,000. $13,000 ÷ 3 = $4,333.33). 

Why Annual Recurring Revenue is important

As we’ve previously discussed, metrics can be powerful tools for capturing, predicting, or assessing business processes or health. When it comes to annual recurring revenue, it is an especially useful metric for subscription businesses. ARR is important to subscription businesses for the following reasons:

• Forecasting Revenue: Using ARR, companies can forecast revenue for years ahead as they factor in subscriptions with long term contracts.
• Estimating Churn: ARR calculations capture churn (lost customers or downgraded subscriptions), providing a sense of where a business may be vulnerable. As a result, companies can strategize well in advance to compensate for churn. 
• Planning for the Future: Outside of forecasting future revenue, companies can also use those ARR-fueled forecasts to project the funds available for research and development. 
• Putting a number on growth: In comparing the year-to-year trajectory of ARR, businesses can identify areas of operation that are the most conducive to growth. They can then take that information and make judgements about sustainability and future growth.
• Quantifying the subscription model: Because ARR focuses on subscription-based revenue, it can help executives better understand the strengths and weaknesses of their subscription model without having to separate out the various costs and fees involved in one-time charges or single transaction business models. 
• Understanding overall company health: Finally, ARR serves as an accurate indicator of company health. It provides a clear picture of a company’s strengths and weaknesses, leading to better overall decisions about operations, recruiting, development, planning and finances.