Today’s businesses follow many types of revenue models. Perhaps the most common, oldest example is a one-off transaction in which a product is exchanged for currency. This takes place when you pop into a store to purchase a bottle of water. Other examples include leasing/renting, contractual, commission-based, and subscription-based (or recurring revenue) model.
In this article, we focus on recurring revenue. It is distinct from the one-off model because the latter only allows you to sell the product once. This forces you to focus more on attracting new customers than retaining existing customers.
On the other hand, with recurring revenue businesses charge a repeated fee charged on a set cadence. This changes businesses’ approach to marketing and selling their offerings. The focus shifts towards finding a balance between acquiring new customers and retaining existing ones.
Retaining existing customers is five times cheaper than acquiring new ones. It’s a major benefit to having a recurring revenue-based business. But that’s just one reason to take this approach.
For example, software as a service (SaaS) companies continue to develop new tools for businesses and individuals. SaaS systems are typically subscription-based, with recurring payments.
The consistent revenue generated makes this an increasingly attractive approach. Let’s take a closer look and understand why it is so popular, starting with a quick overview for those who might need a refresher on the topic.
What is recurring revenue?
As the term suggests, it is the revenue a company generates through repeat payments from the same customer. Instead of asking for the whole payment upfront, the overall cost of buying the product or service is spread across a longer period in which the customer pays the premium at regular intervals.
Modern software companies have found this model to be more beneficial from a sustainability viewpoint. Hence, many companies are shifting to this model if they haven’t already.
Now, let us look at the different methods through which companies generate this type of revenue.
Types of recurring revenue
This varies, depending on a company’s industry and product type. An eCommerce brand would have a totally different way of generating regular income than a software company.
Below are the different sources through which software companies generate recurring income.
This is the most common model followed by modern software-as-a-service (SaaS) companies. Customers pay for the service on a recurring basis. They make an upfront payment to use the service.
The company, based on its pricing structure, would allow them to use the service until their subscription expires. At that point, the company hopes the customer renews their subscription.
A renewal locks in another year (to use an example timeframe) of recurring revenue. This can continue for years or decades, during which the business generates a significant amount of revenue from that customer. This is why customer retention is so important to businesses based on a recurring revenue business model.
This revenue model is common in service-based companies. Vendors agree to provide their service to their clients for the length of time mentioned in their contract.
They create a service level agreement that specifies the deliverables which the vendor would provide to the customer. Once the contract expires, service is suspended unless the customer renews it.
Once a customer starts using a vendor’s product, there are many opportunities for new business that emerge during the relationship. In a product-based company, products are always in the state of upgrades which they regularly introduce. And they have other related products too which would enhance the customer’s usage experience if they purchase them.
Hence, companies approach customers with various upselling and cross-selling proposals to sell a higher-end product or a supplementary one. This continues in the customer journey and is a source of dependable revenue.
Benefits of recurring revenue
The benefits of this model extend to both the customer and the business. Below we cover both.
- It is a big decision to purchase a product for a lifetime. Customer won’t truly know how useful the product is until they start using it. By paying for a shorter-period subscription, customers can try the product and verify its usefulness before they renew the subscription.
- Customers have the freedom to switch to another vendor whenever they want. The cost of moving to another vendor varies.
- Since a customer is not bound by a long-term contract, businesses take better care of customers in hopes that they will renew their contract or otherwise stay with their current vendor.
- Customer acquisition tends to be easier. It’s cheaper for the customer to pay for a subscription than pay full price to purchase the offering outright.
- Businesses have the ability to better predict their chances of achieving long-term sustainability. Through long-term strategies, businesses get a chance to increase their market lifespan.
- The lifetime value of the customer tends to be greater than what they would generate through a one-time purchase.
Ways to calculate repeat business and revenue
When it comes to calculating recurring revenue, there are three metrics you must know. Those are annual recurring revenue (ARR), monthly recurring revenue (MRR), and customer retention rate.
- ARR refers to the amount of revenue generated in a year. The formula used to calculate ARR is very simple. It is calculated by dividing the total revenue generated by your company over a specific timeframe with the number of years a customer is with a company.
- Likewise, MRR is the monthly revenue your company generates. You divide the total revenue earned in a given time by the number of months the customer pays to calculate MRR.
- Retention rate is the percentage of existing customers retained. If no customers leave in a year, then the retention rate for that year would be 100%.
The use of MRR vs ARR varies from company to company. SMBs generally use MRR whereas large enterprises prefer to use ARR.
Ways to grow it
You can apply many tactics to increase recurring revenue. They range from introducing changes to your pricing plan to penetrating new markets with new offerings. Let us look at a few of them below.
Some customers inevitably leave after their initial period of product usage. A great way to retain them is to provide a well-planned and organized onboarding process. This ensures higher levels of product adoption, which leads to higher levels of customer success. That. consequently, leads to more renewals and a lower customer churn rate.
After product adoption, you must continuously engage the customer to show them the value of your product. Otherwise, their product usage could drop and they could leave you for a competitor. Keep them engaged and always add value to their business so they continue to pay for your service.
Upgrade your product or service
Product upgrades involve adding more features to it. You may keep this higher version product at a higher price and recommend it to your existing customers. When they shift to a higher-priced product, your MRR or ARR would naturally rise.
Sell related products
It’s advantageous to recommend your additional offerings to existing customers. It’s smart to wait until they are comfortable and successful using their initial purchase before pitching an additional one.
Recurring revenue businesses are booming in the modern SaaS industry. Customers have redefined the ball-game. They are more actively involved in a given company’s strategies than ever before.
Keeping customers loyal helps you survive in today’s increasingly competitive business landscape. They are reliable sources of revenue and would keep your company breathing as long as you add value to their business.28
Recurring income may appear smaller in the beginning but when considering overall customer lifetime value, it gives you a greater ROI than most other options. It is important for maximizing net profit and ensuring the long-term survival of your business.
Rakhin has over 10 years of experience driving business development and client services. In his prior roles, he stayed close to customers to understand their requirements and help them achieve their business goals. He is passionate about customer success.
Published August 16, 2020, Updated March 02, 2023