What is Annual Recurring Revenue (ARR)?
Whether you offer short-term contracts or multi-year contracts, annual recurring revenue (ARR) is a key metric for businesses studying the financial health of their subscription model.
Like every other company, subscription brands like BarkBox, Twitch, FabFitFun, Sling, Blue Apron, and Dollar Shave Club were shocked when the COVID-19 pandemic hit in 2020. However, rather than shrinking, the subscription space saw increased growth rates since more people were shopping online. During the first weeks of COVID, new subscriptions increased by 20%-40%—and by April, new subscriptions hit a peak growth of 85%.
Research shows that one in three consumers purchased a new online subscription for COVID-related reasons, such as securing child-friendly entertainment during stay-at-home orders. On average, consumers spent $192.30 on new subscription services.
If you are in the subscription space, your goal is to attract and retain customers so that you generate recurring revenue. You can better understand the health of your business and make more informed business decisions by staying mindful of critical metrics like your ARR.
Recommended reading: Subscription business model metrics guide
What is annual recurring revenue (ARR)?
The ARR metric shows the predictable annual revenue for a business in a year. Businesses that operate on a subscription-based model are most likely to benefit from ARR calculations. If you are familiar with monthly recurring revenue (MRR), ARR is the annualized version of this measurement.
Why should a subscription-based business care about ARR?
When your business collects revenue from subscriptions, ARR tells you your annual basis revenue based on what you expect to receive from your customers.
ARR is a metric that helps you better understand your company's growth.
By evaluating your subscription model using ARR, you can better forecast expected revenue. From there, your business can forecast future revenue and make longer plans.
When you break down annual recurring revenue into components such as ARR from current customers' upgrades and ARR from new customers, you better understand what factors are contributing the most to your revenue.
How does ARR differ from MRR?
While annual recurring revenue (ARR) and monthly recurring revenue (MRR) are similar metrics, they cover different time periods (a year vs. a month).
ARR offers insight into your company's recurring revenue on a macro-scale, compared to MRR, which is calculated on a micro-scale. Therefore, ARR offers greater long-term insight, which is critical for both your company's management and investment opportunities.
ARR is most beneficial for viewing year-over-year financials to improve planning. MRR allows you to dive deeper, so you can see the immediate effects of any changes or developing strategies. It also allows you to view revenue fluctuations at different times of the year.
What's the ARR formula to measure your business health?
To calculate ARR, divide the total contract value by the number of years. However, consider that not every business will use the same annual recurring revenue calculation. Your business's ARR formula depends on several factors, including the complexity of your subscription business model.
While calculating ARR, keep the following in mind:
ARR only considers recurring revenue. This means you must exclude any variable or one-time charges in the same period of time, like one-off item orders.
ARR is intended to assist you in developing a detailed understanding of the momentum around your company's ARR from new customers, existing customers who renew, incremental increases (add-ons and upgrades), and ARR losses (downgrades, lost customers, revenue churn).
Have a clear definition of ARR within your organization based on your subscription terms, especially if your subscriptions run for a non-standard period—for example, 15 months instead of 12. As long as your records stay consistent regardless of how you structure payments, billing cycles for annual subscriptions (or longer) shouldn't affect your ARR.
ARR formula examples
If a current customer signs up for one of your multi-year subscriptions, you will divide the contract's revenue by the contract term length. Take a 3-year contract for $5,500 divide $5,500 by three. This gives you an ARR of $1,833.33.
To calculate decreases, take the same approach. For example, if a customer does not renew a $8,000 contract over two years, divide $8,000 by 2 for an ARR decrease of $4,000.
Here is another simplified calculation that considers the most common variables:
ARR = (annual subscription cost + recurring revenue from add-ons and upgrades) - lost revenue from cancellations.
Here is an example based on a three-tier plan structure.
Basic costs $5.99/month, standard costs $10.99/month, and premium costs $13.99/month
If a customer purchased the basic plan for three months before upgrading to premium, the monthly price would increase from $5.99 to $13.99
You can then calculate the total dollar amount of the customer's yearly subscription: $5.99 x 12 months = $71.88
This total is then added to the amount gained through the upgrade: $8 (the difference between the two plans) x 9 months (the remaining period that the upgrade applies) = $72
In this case, there is no dollar amount lost because of cancellations (churn).
The total ARR is $71.88 + $72 = $143.88
If you have focused your attention on building a pricing strategy based on your MRR, here is how you'd find your ARR.
MRR = MRR at the beginning of the month + MRR gained from new customers that month + MRR gained from upgrading customers that month - MRR lost from downgrading customers that month - MRR churn for that month
MRR x 12 = ARR
What ARR can tell you about your businesses
To make more informed decisions, you need to understand the health of your subscription business over time.
Whether you are planning the development of new products or upgraded feature releases, re-evaluating the market, or focusing on expansion revenue, knowing the impact of your decisions is vital.
Calculating annual recurring revenue is one of the most effective methods of gaining that insight, as it:
Provides insight for growth: ARR is the amount of revenue you expect to repeat, which will help you better predict future growth. When you look at data over a 12-month period, you can easily see the impact of any changes you made throughout the year.
Predicts future revenue: When you are aware of your revenue and the cost of lost customers, you can better manage expenses and maintain a positive cash flow. ARR is the foundation of more complex calculations, such as those that determine acquisition goals, pricing, and churn percentages.
Shows the health of your business: By including only the actual revenue you generated in a year, you create an accurate picture of how your business is doing and what that means for the year ahead.
Helps you set more realistic goals: When you stay informed, you can make better decisions. ARR offers guidance for the future, showcasing available opportunities based on the actions that will have the greatest impact.
How does ARR relate to churn in subscriptions?
ARR is a key financial business metric that shows you the total amount of recurring revenue your company expects to receive over the course of a year. Churn rate, on the other hand, is a metric that measures the rate at which customers cancel or unsubscribe from your service over a specific period. ARR and churn rate are related in the following ways:
Seize impact on revenue: A high churn rate can result in a substantial loss of revenue, while a low churn rate contributes to revenue stability and growth. When customers cancel their subscriptions, they stop contributing to your annual recurring revenue, leading to a decrease in ARR.
Measure Customer Lifetime Value (CLV): CLV is an estimate of the total revenue a company can expect to earn from a user over the entire duration of their subscription. Churn rate plays a significant role in determining CLV, as customers who churn early contribute less to ARR and CLV than long-term subscribers.
Design effective growth strategies: Subscription businesses often focus on increasing ARR by acquiring new customers (customer acquisition) and retaining existing customers (customer retention). Lowering churn rate is a key component of retaining customers and growing ARR.
Recurly fuels the growth of subscription model businesses
Recurly is a subscription billing and management platform designed to fuel your rapidly growing subscription business.