Revenue forecasting is an important benchmark in creating strategic plans and making key business decisions. However, the implementation of such a task cannot be based on intuition, assumptions, or guesswork. Grounded decisions require objective metrics, and one of the best for SaaS businesses is Annual Recurring Revenue (ARR).
Definition of Annual Recurring Revenue (ARR)
ARR is a metric that reflects the recurring revenue that a company receives or expects to receive within 12 months. It takes into account only ongoing customer contracts, which are the basis of the subscription revenue model. One-time sales are irregular and are excluded from the calculation formula for this indicator.
How Understanding of ARR Can Help Grow Your Business
ARR meaning is multifaceted, so you can benefit from it in many ways:
- Tracking progress. ARR objectively evaluates the impact of key business decisions on the company’s revenues. Any negative deviations can be a signal to revise the company’s pricing policy.
- Building accurate financial forecasts for the future. Investments or expansion of the company’s activities require accurate estimates, which can be provided by calculating ARR.
- Setting realistic business goals. Careful analysis of ARR will help to avoid ungrounded decisions and inflated expectations. Instead, you will receive data-driven decisions that optimize the company’s activities.
- Assessing the sustainability of the business. Financial stability requires recurring revenues. ARR allows you to highlight this type of profit, clearing it of volatile income. This will make your business commitments and new projects sustainable.
Rules for Measuring Annual Recurring Revenue
The calculation of ARR depends on the type of subscription for your business ― monthly or annual.
- With a monthly subscription, the formula is simple: ARR = MRR (Monthly Recurring Revenue) x 12
- With an annual subscription, ARR = (Sum of subscription revenue from all active consumers + recurring revenue received from add-ons and upgrades) – revenue loss due to downgrades or cancellations
ARR Formula Key Variables
- The annual recurring revenue received from new customers and regular customers who renew their subscriptions.
- Revenues received from recurring add-ons or upgrades. This variable includes customers switching to higher-tier plans, add-ons that affect the cost of a subscription, etc.
- Decrease in revenue due to downgrades. Perhaps some customers switched to a lower-tier plan or started using fewer features, which affected the cost of a subscription.
- Decrease in revenue due to churn.
This variable takes into account only loss from those customers whose subscription has ended and they chose not to renew the contract. If the subscription is still active but was simply canceled, this is not included in the formula because such revenue can still be partially recovered.
What Variables Should Not Be Included in the ARR Calculator
Non-recurring payments are one-time revenue and do not belong to repeatable revenue streams. They will not help objectively forecast future revenue. Therefore, it would be a mistake to include the following variables in the recurring revenue formula:
- Service setup fees;
- One-off discounts;
- Add-ons that do not increase the subscription price;
- Credit adjustments;
- Other one-time charges.
How to Optimize ARR for a Subscription-Based Business
To understand effective ways to maximize ARR, a business should pay attention to other key metrics:
- LTV ― Lifetime Value or the amount of profit a SaaS company receives from one consumer for the entire time he or she uses the company’s services.
- CAC ― Customer Acquisition Cost or the funds that a company spends on attracting one client. This can be the cost of marketing research, advertising campaigns, discounts and bonuses for new consumers, etc.
The ARR metric depends on the values of these two indicators. To increase ARR, you need to strive for the following:
- Expand your customer base, but at the same time minimize CAC with the help of more effective customer acquisition strategies.
- Try to increase LTV with the help of personalized offers, profitable loyalty programs, etc. But remember that the costs of supporting such loyalty programs should be lower than CAC. Otherwise, attracting new customers will cost you less than retaining existing ones.
- Encourage upgrades to tariff plans with useful add-ons. Constantly work on improving your service and expanding the set of features available on higher-tier plans. This will encourage regular customers to upgrade to more attractive premium plans.
- Refine pricing strategies using AI and ML. Develop a tariff grid in such a way that new consumers easily agree to a subscription. At the same time, it should be multi-level to encourage regular customers to upgrade to more expensive tariff plans as their business scales. Use the Competera pricing platform to correctly determine price points.
- Study effective ways to reduce CAC to increase the company’s revenue. This indicator also affects ARR. Because the cheaper a new consumer costs you, the more of them you can attract with a fixed CAC.
Difference in Using ARR and MRR
Both metrics are useful for assessing the company’s performance and development prospects.
However, you will rely on one of them depending on your goals:
- If you are faced with the task of monitoring business income, then MRR will provide more detailed information. This metric will highlight those factors that led to the growth or decline in income.
- If you want to make a long-term financial forecast, then the ARR metric will be more effective. It will show the trajectory of business development and stable trends.
The Bottom Line
The ARR indicator is needed not only for an objective assessment of the company’s success. Based on it, you can develop a set of proactive actions aimed at optimizing recurring revenues. When implementing this strategy, do not forget to take into account the MRR. See how it changes under the influence of a new pricing policy, offering new features, conducting a marketing campaign, etc. In this way, you will identify effective ways to increase recurring revenues and discard those that do not produce the expected effect.
