What is Annual Recurring Revenue (ARR) and How To Calculate It

Updated On: April 22, 2019
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Metrics – with the right context and understanding – are powerful tools. They help you frame the success of your business, lead to stronger forecasting, and propel your company's growth strategy.

For subscription companies, annual recurring revenue (ARR) is one of those metrics. It gives you a high-level overview of your business health and helps you calculate the rate at which you need to grow to keep building on your success.

What is ARR? Annual Recurring Revenue Explained

Annual recurring revenue (ARR) is an essential SaaS metric that shows how much recurring revenue you can expect, based on yearly subscriptions. ARR is a momentum metric that highlights the compounding growth of your business and represents the annualized version of monthly recurring revenue (MRR).

How do you calculate ARR?

The way you calculate ARR will depend on a number of factors, including your existing pricing strategy and the complexity of your business model. As a fundamental metric for contextualizing your overall growth and the momentum at which you can scale, there are many factors that come into play.

We've put together a basic equation to help you get started.

 

The ARR formula

To calculate ARR, take the overall subscription cost per year and add in any recurring revenue gained through expansion revenue (add-ons and upgrades). Then, subtract the revenue lost to cancellations.


ARR Formula

 

It's important to note that any expansion revenue earned through add-ons or upgrades must affect the annual subscription price of a customer. Any one-time options should not be included in this calculation.

If your pricing strategy is built more on monthly recurring revenue (MRR), you can also calculate the ARR by multiplying MRR by 12.


The Calculation_ True MRR (1)

 

Figures you will need

Any changes to these metrics will affect your calculations directly.

  • Customer revenue per year — The basis of your ARR calculation. This is the total revenue accrued each year through annual subscriptions.
  • Add-on purchases — Any purchase that increases the annual subscription price on an ongoing basis.
  • Product upgrades — Any upgrade that increases the annual subscription price on an ongoing basis.
  • Product downgrades — Any downgrade that decreases the annual subscription price on an ongoing basis.
  • Cancellations (Churn) — Account cancellations and customers lost due to churn that results in lost revenue.

What is the difference between ARR and MRR?

Both ARR and MRR are both great ways to track and contextualize your recurring revenue at different levels. As a subscription company, it's this recurring revenue that underpins your pricing strategy and business model – that's why it's important to have a solid understanding of these metrics. Each highlights the momentum with which your company can grow.

 

Annual vs. Monthly

The main difference between ARR and MRR is that ARR is calculated annually while MRR is calculated monthly. ARR represents your company's recurring revenue on a macro scale and MRR on a micro scale.

The importance of calculating both

Both ARR and MRR provide valuable insight into the health of your business. You can use this data to forecast how revenue will compound as your company grows and then plan what you can do with that revenue.

With ARR, you're able to see year-over-year progression at a high level, which is useful in long-term product planning and creating company road maps.

MRR dives deeper, showing you how the company grows on a month-by-month basis. This is a good way to measure the immediate effects of any changes to product or pricing strategy. It's also a way to track incremental fluctuations related to customer health at different times of the year.

Combined, you're able to more effectively plan your road map and check your progress every month. That gives you more data to inform decisions, pivot more quickly, and ultimately provide a better overall customer experience.

Why ARR is a vital metric for subscription businesses

To track the health of your subscription business over time, you need in-depth knowledge of the company's current financial standing and how you're stacking up to yearly growth goals. Whether you're re-evaluating product-market fit, planning for new feature releases, or doubling down on expansion revenue, knowing the real-world impact of your decisions is paramount.

ARR is one of the best ways to find that.

 

Provides a figure for tangible growth

As a momentum metric, ARR gives you the purest measure of how your recurring revenue compounds over time. Use it to map out the best and most efficient path forward for your company and easily see the impact of the changes you've made on a year-over-year basis. ARR acts as the compass you can use to track growth.

Allows you to forecast future revenue

ARR is the baseline on which you can build more complex calculations. By cross-referencing your churn percentages, acquisition goals, or potential changes to pricing and packaging against ARR, you're able to build a reasonable picture of what success looks like in the future. Without ARR, you'll never be able to understand the real customer impact of the choices you make for the company.

Enables you to set realistic goals

You're not a fortune-teller, but a strong understanding of your company's ARR is as close as you'll get to a crystal ball. This metric provides you with valuable context for future decision-making. With it, you can see areas of opportunity in your current business model and know what actions will have the greatest effect. This helps you make more realistic plans that you can actually follow through on.

Shows a subscription business's overall health

We know that subscriptions are the crux of your business model. Tracking the total yearly dollar amount of those subscriptions is the only way you'll know exactly how much revenue your company is making. By including only the real revenue generated through your subscriptions, you create the most accurate picture of the health and success of your business.

A real-world ARR example with Netflix

Streaming services like Netflix are some of the most successful subscription companies around. They've mastered the art of value-based pricing so well that even established media moguls like Disney have thrown their hats into the ring. But without a clear understanding of how their pricing affects recurring revenue, Netflix would have a difficult time keeping pace with their competition.

We'll walk through the ARR formula based on Netflix's pricing page to show you how easily it can break down their three-tier pricing strategy.


Netflix Pricing Page

 

Netflix subscription

In this example, we'll start off with a customer purchasing Netflix's Basic plan at $8.99 a month. If, after three months, the customer chooses to upgrade to Premium, the monthly price increases to $15.99. From there, our example customer chooses to keep the Premium package for the rest of the year without any signs of downgrading or canceling.

Let's say the customer subscribed for three months before upgrading to Premium:

Total $ amount of yearly subscription: $8.99 X 12 months = $107.88
Total $ amount gained through Premium upgrade: + $7 (for a total of $15.99) per month for the remaining 9 months = $63
Total $ lost due to cancellations (churn): $0
ARR:   $170.88


Let's say the customer subscribed for six months before upgrading to premium:

Total $ amount of yearly subscription: $8.99 X 12 months = $107.88
Total $ amount gained through Premium upgrade: + $7 (for a total of $15.99) per month for the remaining 6 months = $42
Total $ lost due to cancellations (churn): $0
ARR:   $149.88

 

If Netflix has fifty customers who upgrade to Premium after three months, that means the ARR for those customers is 50 X $170.88 for a total of $8,544.

And fifty customers who upgrade after 6 months would be 50 X $149.88 = $7,494.

You can see how Netflix's pricing strategy and their customers' choices factor into these calculations. To see the ARR for Netflix's entire service, they would need to factor in all of the different account levels, upgrades, downgrades, or cancellations within a calendar year. Following this formula, Netflix would be able to calculate the most accurate representation of their recurring revenue health possible.

Conclusion

ARR is a key metric for any subscription company. With this data, you'll be able to not only check in on the overall health of your company but also see how any actions you take either increase or decrease overall growth momentum. Recurring revenue is a compounding indicator of your ability to grow.

Being able to track these fluctuations also helps you see the best path forward for your company. The more recurring revenue you generate, the better products you can create and the better team you can build. Without ARR as the baseline, it will be impossible for your company to understand its continued success.

Tags: pricing strategy, SaaS pricing

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