The subscription economy is growing at an unprecedented rate. As per reports, the subscription economy has grown more than 435%* in the last 9 years – which translates to nearly 6x growth in less than a decade. Amazing, isn’t it?
With the growing demand for subscriptions and the businesses performing at their peak levels, the trend for subscription services does not seem to decline anytime soon.
Subscription businesses too – like any other business depend on revenues to expand and meet their growth objectives. One of the most important metrics that is used to study a subscription business’s health is the – Annual Recurring Revenue aka the ARR.
What is Annual Recurring Revenue?
If you are somebody familiar with the subscription business, you might have heard the term ‘ARR’ a lot.
But what is ARR?
In terms of subscription or the SaaS economy, ARR is the estimate of the amount of revenue the company can expect to generate from their paying subscribers every year, based on the contract term (the number of years the customer signs up for a particular service).
In simple terms, it tells you how much revenue will come from a subscription every year for the entire life of the subscription.
For example, if a customer signs up for a service worth $10,000 for a term of two years, the annual recurring revenue would be $5000 for each year.
What is the importance of ARR for subscription businesses?
One of the most attractive features of a subscription business model is the ability to predict revenues to a considerable limit.
This revenue is a key ingredient in the success recipe of a subscription business. And ARR – ups your revenue game.
- Predicts business health: ARR can act as a compass that directs your business toward growth and success. With the ability to predict revenue on a year-on-year basis, you can carve out better strategies and launch new products and plans with much more confidence.
- Acts as a baseline for other business calculations: ARR when used with other accounting metrics can help you give a solid forecast of your company’s future. You can cross-reference ARR with metrics like the churn rate or acquisition goals to make more informed decisions.
- Supports decision-making: Though the world of business is always at the risk of disruptions and dynamic changes now and then – the ARR will give you a solid foundation to stand upon. You can use it to make important business decisions – like the launch of a new product.
- Attract investors: Since ARR is the key metric that reflects the profitability and stability of a subscription business – it is something your investors would be most interested in. It shows the growth trajectory of your business.
- Helps identify growth channels: ARR helps you understand and identify which regions or areas are performing better than others. You can put more energy into high-performing areas while working on the pitfalls of the low-performing ones.
How to calculate Annual Recurring Revenue (ARR)?
To calculate the ARR, you can take the total value of the subscription and divide it by the number of relative years.
If a customer signs up for an annual contract for a term of two years at a value of $50,000, the ARR would be:
ARR = $50,000/2 i.e., $25,000 for each year.
Though it seems relatively simple, you need to be very careful about what elements you are including in the ARR calculation. By nature, you should only include recurring values. Also, as ARR is a non-GAAP measure, it is not subject to audit.
If your pricing model is monthly, you can calculate the ARR by multiplying Monthly Recurring Revenue (MRR) by 12.
You should also know that, unlike other revenue figures, ARR focuses on the future earnings of a company. So, it is a forward-looking metric.
Factors or elements that affect ARR
ARR calculation also considers a variety of other factors. Any changes to these factors can also affect the ARR. Some of these factors include:
- Customer revenue per year: This is the foundation of ARR calculation. You should cover all recurring invoices as well as renewals.
- Product upgrades: Include all upgrades that can increase the annual subscription value.
- Add-ons: Include add-ons that can increase the value of the subscription, on a yearly basis.
- Downgrades: Just like an upgrade, you should also include any downgrade that will decrease the total annual value of the subscription.
- Churn: You should also consider any account cancellation that can result in lost revenue.
Things that should not be included in the ARR
As mentioned before, ARR is a forward-looking metric and only considers recurring revenues. So, you will need to ignore non-recurring charges, like:
- Any set-up fees
- Non-recurring add-ons
- One-time fees
An important point to note here is that if the term of the subscription is less than a year, you should ideally use MRR (Monthly Recurring Revenue) as the basis of the prediction.
ARR vs MRR – what’s the difference
While ARR is calculated for annual terms, MRR gives you a much more detailed view of your company’s growth. There are different types of MRRs – upgrade MRR, contraction MRR, new MRR, and more. This is great for measuring the immediate effects of a product or pricing strategy.
While MRR gives you a short-term vision of your business, ARR is and should be used for long-term predictions. So, calculating both MRR and ARR gives you a comprehensive overview of your subscription business.
By using both the metrics, you’ll be able to plan your business strategies and road maps more effectively. You can make more informed decisions and pivot quickly to ultimately earn better revenues and deliver a great customer experience.
ARR and subscription business – how to grow your ARR?
We talked about everything from what is ARR, and its benefits to how to calculate it. Now, let’s look at a few tips you can follow to improve your SaaS or subscription business’s ARR value:
- Find your focus areas: ARR helps you find areas that can bring more revenue to you – like a particular region or a service. Your objective should be to work more in these areas and convert them into growth channels.
- Increase your ARPU: Start working on strategies to increase your Average Revenue Per User. Your existing customers are your greatest asset. Offer them more features, cross-sell products, and add-ons to develop a lasting relationship and earn more from a single subscription customer.
- Promote your annual plans: ARR is a metric that is calculated mostly on longer terms. Create plans that promote longer-term contracts. You can genuinely try and make annual plans more beneficial from the end customer’s POV as well, by offering them discounts.
- Work on customer churn: Understand why your existing customers are leaving. Work on delivering higher customer satisfaction and building a long-lasting relationship with them.
- Get new subscribers: This is the most obvious tip; you stand a chance to improve your ARR when you have more subscribers. But do not forget to keep customer acquisition costs low – to generate positive ROIs for your business.
- Focus on your pricing strategy: Your pricing plays a key role in customer retention and acquisition. Work on offering value-based pricing.
- Explore channel partnerships: Once your primary demand generation channels are optimized, you can start exploring channel partnerships. It is a great way to expand your product’s reach.
RackNap, as a subscription business billing and management software, can help you automate various aspects of your subscription business. Learn how you can optimize your business processes via automation and deliver a better customer experience and build a strong customer base for higher revenues. Book a demo today.