What Is Annual Recurring Revenue (ARR) in SaaS: How to (Correctly) Calculate and Use It
If you are into a recurring revenue business model, then it is imperative for you to understand what is ARR and how to calculate it. Read on to know more.
Sep 17, 2020
SaaS businesses have progressively realized the immense benefits of recurring revenue. That’s why they have brought in the wave of a subscription-based delivery model in the software industry. If your business is into a recurring revenue model then it is imperative for you to understand what ARR is.
Although the term Annual Recurring Revenue sounds quite simplistic, there are many nuances associated with this topic. We are going to discuss all of them in this blog.
It has been ubiquitously agreed that the revenue you can generate from a customer over a long-term relationship is much bigger than one-off purchase. This is the core belief that has changed the entire business model of the modern SaaS companies. It has not only given rise to a new department – customer success – but also changed the entire mechanism of revenue calculation.
Naturally, with such a change in the core working of business entities, the overall strategies should also undergo change. Companies never used to calculate their annual recurring revenue before, but now it has become one of the major metrics to calculate. So, let’s examine this in detail.
What is ARR?
Annual recurring revenue is the overall annual revenue generated from your existing customers through their various spendings on your business. ARR gives you a clear picture of how your business is generating revenue through its installed base. It indicates not just how good you are at acquiring new customers but in retaining the existing ones too.
It is one of the key parameters through which investors check the health of your business. It brings financial stability and consistency in an organization through which the growth trajectory can be predicted.
Why is measuring ARR important?
While monthly recurring revenue (MRR) is closely associated with ARR, they are both used in conjunction in many companies. The MRR usually helps you in short-term planning, while the ARR usually brightens the path for long-term growth. Since large enterprises (with more than $10 million) usually plan more long-term strategies, ARR is mostly used by them.
Let’s see how using this SaaS metric helps them in different areas.
Determining the Customer Acquisition Cost (CAC)
After the business has sustained for few financial years, they can start calculating their ARR. This metric helps them in calculating the time needed to recover the CAC. Through ARR they calculate a customer’s lifetime value (LTV). The CAC to LTV ratio for any successful business must be 1:3. SaaS giants like Salesforce have it upto 1:5.
Determining production budget
When you have an existing customer base, you need to grow your offerings through new products. By calculating ARR, you can know the budget to allocate for producing new products. This in turn will help in raising your ARR for the next year.
By measuring your revenue on a year on year basis, it helps your financial experts to chart your growth trajectory. This information is valuable in a lot of sense. The business owners can plan their overall strategies around this SaaS metric. Investors can decide the worth of the business and its capacity to generate recurring revenue.
How to calculate ARR?
To calculate ARR for any given year, you need five values.
Revenue at the beginning of the year (A)
Revenue generated so far from new customers (B)
Revenue generated from existing customers through upsell or cross-sell (C)
Revenue lost by downgrading customers (D)
Revenue lost by churned customers (E)
So, the total ARR would be all the revenue generated in a year minus all the revenue lost due to churn or downgrading.
Hence the formulae for annual recurring revenue is, ARR = A + B + C – D – E
To calculate MRR, divide this amount by 12 and you will get monthly recurring revenue.
How to grow ARR?
By now, you would have realized that the ARR is the clear indicator for any business growth. So, every business must aspire to increase its value with time. Here are few ways you can do so.
Although we are talking about recurring revenue everywhere in the SaaS business, the new customer acquisition is still indispensable. All the business starts with new customers. Hence, it is the first step towards accumulating your ARR. The marketing and sales division must perform their best to acquire new customers.
Promote annual plans
With annual plans, the path to grow ARR becomes straight and clear. Although you cannot make it imperative, you must encourage your customers gently to switch to annual plans. Give them more benefits for purchasing an annual membership. This way it will be easier for them to consider it and switch.
You must regularly approach your customers for growing more business with them. It can be in one of the three forms:
Through one or more of these ways, you can expand business through your current customer base. The expansion ARR gained from all of the above ways would be quite beneficial for your business.
One thing that differentiates ARR from MRR, is that this metric is more used by enterprise business. While MRR is more used by SMBs. So, to grow your ARR, you need to strategize your marketing and product to fit the enterprise customers. Your pricing plan should also cater them.
Big enterprises have much larger complexity of business needs. Make sure you have the right team ready to give a bespoke solution to them. As long as they derive long term value, they won’t mind subscribing to your business on an annual basis.
By understanding what ARR is in this blog, you would have known how important it is to grow it. The core solution for generating higher ARR can never be better than customer retention. The subscription economy has made customer success irrevocably an integral part of any new organization. Hence, all the strategies that your customer success team implements, ultimately adds up to raising the annual or monthly recurring revenue.
You need to help your customers succeed in achieving their business goals through your product. There are various strategies that the customer success team implements towards this objective. Our whole organization is built around helping customer success teams achieve their goals. So, if your customer success team is executing its tasks flawlessly, the annual recurring revenue growth would be a natural outcome.
Shoeb lives and breathes Customer Success and SaaS. He has a passion to research on the latest innovations happening in SaaS and Customer Success. Shoeb hails from a Software Architecture background where he worked for many years with Indian Tech Giants like Wipro and ITC building software solutions for their MNC clients in the UK and Denmark.