Do you know which metrics Software as a Service (SaaS) companies track to make data-driven decisions?
SaaS businesses that are aiming to enhance efficiency and drive revenue growth need to have a steady stream of data. Hence, they engage with a range of SaaS metrics. One of the key metrics that SaaS companies can use to determine their company’s growth rate is Total Contract Value (TCV).
Total Contract Value, or simply contract value, captures the full worth of a contract over its duration. When accurately assessed, TCV offers companies a clear view of the yearly value generated by each customer contract and the effectiveness of customer acquisition strategies.
Understanding the total worth of contracts is crucial for developing strategies that are profitable and bring long-term success to business.
In this article, we’ll dive deep into the concept of TCV, including how to calculate it, and providing additional insights and practical advice on leveraging it effectively.
Let’s get started!
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What is Total Contract Value?
Total Contract Value simply means the total money you get from a customer. This includes the regular money you get from them, like subscription revenue, plus any one-time charges related to the contract, such as setup fees.
TCV is an important number for businesses that sell subscriptions because it shows how much money you can expect to make from a customer over time. Knowing the TCV from all your customers helps companies plan how much they can afford to spend on growing the business, making new products, or other expenses.
Benefits of Total Contract Value in Subscription Businesses
TCV is important for people who start a subscription business. Here’s why:
- Planning Revenue Forecasting: TCV gives a clear picture of expected future income by including all sources from which a company earns money and details from contracts.
- Analyzing Customer Acquisition Cost (CAC): With TCV, leaders can figure out if the money spent on getting new customers is worth it. This helps in planning how to spend on marketing and sales more wisely.
- Setting Right Prices: TCV can show if a company’s prices are working well or if changing them could make more money over time.
- Comparing Customer Lifetime Value (CLV): By comparing TCV with how much money a customer brings over time (CLV), SaaS businesses can make sure they’re earning enough compared to what they spend on keeping customers around. This is about keeping profits healthy.
How to calculate Total Contract Value (TCV)?
TCV is crucial for SaaS companies because it helps track sales and marketing costs and forecast the average ROI (Return on Investment). Yet not all SaaS companies are familiar with how to calculate TCV. The formula for calculating your company’s TCV is simple:
Total contract value = (monthly recurring revenue x contract term length) + one-time fees
For instance, imagine you sign a deal with a customer who agrees to pay INR 5,00,000 every month for 24 months.
Additionally, there’s a one-time setup fee of INR 90,000 for getting the customer started on your service, transferring their data, and training their staff.
To calculate your TCV, you add this setup fee to the total of the monthly payments (500000 x 24 + 90000 = INR 1,20,90,000).
TCV will change if there are adjustments to the contract’s length or the monthly recurring revenue (MRR). Any modifications in MRR or changes in contract duration can significantly impact the TCV. It’s important to consider these changes when comparing TCV figures, especially if you’ve revised your pricing strategy or contract terms.
Unlike customer lifetime value (LTV), which is based on projections, TCV is based on actual contract agreements. Therefore, you cannot calculate TCV for subscriptions that renew monthly or have indefinite terms because the contract length is unknown. For one-time payments, the TCV is simply the total payment received from the customer, as there’s no recurring revenue component.
Another Example of TCV Calculation:
Consider Plesk, a web hosting control panel that offers various pricing plans based on customer needs. Here are the TCV calculations for two hypothetical Plesk* customers:
Customer A: Chooses the Admin Edition plan at INR 1,387 per month for a 12-month contract.
CUSTOMER A TCV Calculation:
Total contract value = 1387 × 12 + 0 = INR 16,644
Customer B: Opts for the Pro plan at INR 2,080 per month for a 12-month contract, with an additional one-time onboarding fee of INR 2,000.
CUSTOMER B TCV Calculation:
Total contract value = 2080 × 12 + 2000 = INR 26,960
After calculating the TCV for Customer A (INR 16,644) and Customer B (INR 26,960), Plesk can now use these figures to gain insights into its revenue streams over the contract terms. Here’s how:
Revenue Forecasting
- Short-term Revenue Projections: TCV provides an immediate understanding of the revenue that will be recognized over the contract term. For instance, Plesk can anticipate a guaranteed revenue of INR 16,644 from Customer A and INR 26,960 from Customer B over the next year, assuming no contract cancellations.
- Cash Flow Management: Knowing the TCV helps Plesk manage its cash flow effectively. It can allocate budgets for upcoming expenses, knowing that it has a certain amount of revenue locked in from these contracts.
Strategic Planning
- Comparing Customer Value: By comparing the TCV of different customers or customer segments (Customer A vs. Customer B), Plesk can identify which segments are more profitable and tailor its marketing and sales strategies accordingly. This insight shows that customers opting for higher-tier plans with additional one-time fees (like Customer B) bring in more revenue, potentially guiding Plesk to focus on attracting similar profiles.
- Investment in Customer Acquisition: Knowing the TCV, especially when compared against the Customer Acquisition Cost (CAC), helps Plesk understand the return on investment in acquiring new customers. If the CAC is significantly lower than the TCV, the company can justify increasing its marketing spend to attract similar customers.
Forecasting Long-term Growth
- Revenue Trends: Over time, analyzing the TCV across many customers provides a trend analysis. If Plesk notices an increasing TCV, it may indicate that customers are willing to commit to longer terms or higher-value services, signaling a positive growth trajectory.
- Product and Service Development: Understanding which products or services contribute most to the TCV can guide product development and improvement. If higher TCV is consistently associated with certain features or services, Plesk might prioritize these in its development roadmap.
Strategies to Increase Total Contract Value
Increasing the Total Contract Value is a strategic goal for many SaaS companies, as it directly impacts revenue and growth. Here are several strategies that can be employed to increase TCV:
Upselling and Cross-Selling
- Encourage existing customers to upgrade to a more premium version of your product that offers additional features or benefits.
- Offer complementary products or services that add value to the customer’s original purchase.
Bundle Offers
- Create bundles of services or products that provide a complete solution for a slightly higher price than standalone offerings.
Extend Contract Length
- Incentivize customers to commit to longer contract terms by offering discounts or additional services for extended agreements.
- Provide discounts or additional features as incentives for customers who renew their contracts ahead of time.
Enhance Customer Success
- Provide exceptional onboarding experiences and continuous training, which can lead to increased reliance on your service and longer contract commitments.
- Excellent customer support can increase customer satisfaction, leading to renewals and longer-term contracts.
Change Pricing Strategy
- Develop a multi-tier pricing strategy that encourages customers to choose higher tiers by clearly demonstrating the added value.
- Implement small annual price increases for your services to account for the added value over time.
Improve Product Features
- Regularly update and improve your product to make it indispensable to your customers, justifying higher TCV.
- Use customer feedback to provide customized solutions that meet specific client needs, warranting higher contract values.
Challenges in using Total Contract Value
Total Contract Value is a significant figure for those managing company revenues, but it’s not without its challenges.
- The primary issue with TCV is that it’s based on assumptions. It assumes that once a contract is signed, the promised revenue is certain. In theory, yes, but in reality, this isn’t always the case.
- Contracts can and do get canceled. And even with cancellation clauses, the full revenue often remains unclaimed. These clauses are sometimes more about prevention than actual enforcement, similar to the way a decoy security camera is used to deter rather than catch thieves.
Consider this example.
Imagine you secure a client on a 24-month term with a Monthly Recurring Revenue (MRR) of INR 3,50,000 and a one-time setup fee of INR 1,00,000.
Your TCV calculation would be:
INR 3,50,000 x 24 + INR 1,00,000 = INR 85,00,000.
Now, suppose after a year, the client’s company merges with another that prefers a different service provider and they decide to terminate their contract.
If your cancellation policy includes a fee equivalent to three months of service for early termination and you choose to enforce it, the revised TCV would be:
(INR 3,50,000 x 12) + (INR 3,50,000 x 3) + INR 1,00,000 = INR 53,50,000.
So, in reality, the contract is only worth around 54% of your initial TCV projection. While such cases might not happen often, at a larger scale, they’re almost a given. This means that while TCV is useful, it should be applied with caution and in context with other financial metrics.
Difference between Total Contract Value (TCV) and Annual Contract Value (ACV)
While Total Contract Value (TCV) and Annual Contract Value (ACV) both assess the value of contracts, they are not the same and should not be confused with one another. Each metric serves a distinct purpose in revenue measurement and provides different insights into a company’s financial health.
TCV includes all revenue and fees from a contract for its entire duration. This encompasses recurring payments and any one-time fees that a customer is expected to pay. ACV, in contrast, focuses solely on the recurring revenue expected within a single year, disregarding any one-time fees or payments beyond the one-year mark.
The key difference lies in their application: ACV is valuable for understanding the average annual revenue from a contract, while TCV gives you the full picture of what a contract is worth over its lifetime.
Let’s understand this with the help of our previous example with Plesk. Using the earlier figures, Customer B’s TCV is INR 26,960, including a one-time onboarding fee and 12 months of service. To find the ACV, we would only consider the recurring monthly payments for a year, which would be INR 2,080 multiplied by 12 months, equaling INR 24,960.
Unlike TCV, ACV doesn’t necessarily correlate with a company’s success in terms of high or low figures. However, ACV is particularly useful for comparing different customer groups and for analyzing growth. Analyzing the contract value helps subscription businesses understand whether new contracts are contributing to growth or if they are merely extended agreements.
For clarity and strategic alignment within your company, as well as for stakeholders, it’s crucial that ACV is calculated consistently across the board. Uniform metrics prevent confusion and ensure collective understanding and decision-making.
In addition to TCV and ACV, other critical SaaS metrics include:
- Annual Recurring Revenue (ARR): This measures the recurring revenue you can expect annually, providing a snapshot of predictable income.
- Customer Acquisition Cost (CAC): This measures the total cost your business incurs to acquire a new customer, essential for evaluating the efficiency of your sales and marketing efforts.
- Churn Rate: This metric helps you understand the rate at which you are losing customers, impacting your revenue and growth.
SEE: - Customer Churn Analysis: 5 Ways to Analyze Churn Data - What is subscription churn? How to calculate and reduce subscription churn?
- Revenue Run Rate: By analyzing past earnings, this metric forecasts future revenue, helping with short-term financial planning.
These metrics, when used together, offer a comprehensive view of a SaaS company’s performance, allowing for informed strategic planning and decision-making.
Conclusion
Understanding and applying Total Contract Value (TCV) is fundamental for SaaS businesses focused on boosting efficiency and driving revenue growth. TCV serves as a cornerstone for strategic financial planning.
However, when faced with the challenges of TCV, such as contract cancellations or adjustments, businesses must adopt a balanced approach.
To aid in these complex financial analyses, tools like RackNap’s Business Intelligence provide a powerful solution. With this, you can obtain revenue insights on a daily, weekly, monthly, or yearly basis. RackNap can enhance decision-making and help businesses stay aligned with their growth path.
Explore RackNap’s Business Intelligence to transform data into actionable insights and drive your SaaS business to new heights.
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*Disclaimer: Plesk’s examples are hypothetical in nature and do not represent the exact cost of any specific service or plan. Their prices may vary depending on factors like server specifications, software configuration, and more.
