Blog / learnMonday, March 2, 2020

What is ARR and How Can You Use it to Optimise Your Subscription Business?

Tobias Binau

What is ARR and How Can You Use it to Optimise Your Subscription Business?

What Does ARR Stand For?

ARR stands for annual recurring revenue.

If you’re a SaaS business that sells your platform on a subscription basis, ARR can be a powerful metric that will help you:

  • Understand how successful your business is.
  • Make projections for future growth.
  • Inform strategic decision making and business planning.

ARR can be used at a variety of levels within a business and may also be used as a performance indicator for specific departments, or products and services that you sell.

What is ARR?

ARR is used to demonstrate how much money your SaaS business generates every year from a subscription. This can be expressed on a per customer basis, for example, if you use tiered pricing and wish to analyse the ARR of specific customer groups or demographics.

More commonly, it is used to show the value of recurring subscriptions across the whole business, over a one-year period. This helps to normalise revenue metrics and give your SaaS business an accurate overview of how you’re performing if you sell services to different customers and clients with different terms and contract lengths.

For example, if you sign up a new client to a five-year contract at $20,000, this will give you an ARR of $4,000.

Likewise, if you sign up a new client for two years, but at $10,000, then their ARR would be $5,000. 

By breaking down these numbers to express them as ARR, we can see the benefit of doing so. You now know that your ARR for the next two years in this example would be $9,000 if you only had these two clients, while in year three this would drop to $4,000. Consequently, we can see that we need to plan to acquire new customers to avoid our ARR dropping by more than 50% in year three.

If your SaaS business sells subscriptions on a monthly basis, you can still calculate ARR, as all you’d need to do is take the monthly price paid and multiply this by 12.

How to Calculate ARR?

Calculating ARR for SaaS businesses is easy to do.

We have provided formulas to help you do this below, however you can also scroll to the top of this page to use our ARR calculator and get the calculation for your business.

Expressed simply, you get your ARR by multiplying your current customers by the annual price of their subscription. If you used a tiered pricing model, you would need to do this calculation for the number of customers in each tier.

ARR Formula:

ARR = (Number of customers in tier x monthly subscription price x 12 months) + Repeat calculation for each tier.

As we noted earlier, you may have customers that pay over the length of a contract or are on annual subscription plans, so you would simply calculate those figures accordingly before adding into your ARR equation.

Let’s say you have two different tiers, one at $10 per month and one at $15, and express the formula above.

ARR Formula Working Example:

ARR = (60 customers x $10 x 12) + (20 customers x $15 x 12)

ARR = $7,200 + $3,600 = $10,800

Another way to calculate your ARR is to calculate your average revenue per user, or ARPU, and multiply this by 12 for monthly subscriptions. Any annual subscriptions could just be added on, or full contracts and values divided by their contract length in years.

The formula we have used above is just the first part of calculating your ARR. Although you can stop here, if you want to get a more comprehensive figure and outcome, read on.

In order to get a fuller and more accurate picture of ARR, we’re going to show you how you can calculate your ARR from upsells, the ARR you lose due to churn, and how to put all this together for a complete ARR calculation.

ARR From Upselling

If customers upgrade their subscription, move into another tier, or buy something else from you, this will change your ARR.

These extra sales can be added into your ARR figure by multiplying the number of customers by the additional fees they’re paying and subtracting what they would have originally paid.

ARR from Upselling Formula:

Upselling ARR = (Number of customers in new tier x new monthly subscription price) - (Number of customers in new tier x previous monthly subscription price) x remaining months in the year.

Keeping the example we used above, let’s say 10 customers move from your $10 tier to your $15 tier, with six months left remaining in the year.

Upselling ARR Working Example:

Upselling ARR = (10 x $15) – (10 x $10) x 6

Upselling ARR = $150 - $100 x 6 = $300

ARR Reduction from Churn

This measures the opposite to ARR from upselling. We’re now looking at the revenue your SaaS business loses when customers cancel or downgrade.

ARR Reduction from Churn Formula:

Churn ARR = (Number of cancellations x monthly subscription price) + (Number of customers who downgraded x new monthly subscription price) – (Number of customers who downgraded x previous monthly subscription price) x remaining months of the year

For our working example, this time let’s say 10 customers on the $10 subscription cancel and 10 customers with the $15 subscription downgrade to the $10 subscription, again with six months left of the year.

ARR Reduction from Churn Working Example:

Churn ARR = (10 x $10) + (10 x $10) – (10 x $15) x 6

Churn ARR = ($100 + $100 - $150) x 6 = $300

Therefore, in our example, the upsell and the churn would cancel each other out.

Complete Formula for a Comprehensive ARR Calculation

You would therefore define ARR comprehensively using the following equation:

Total ARR = ARR (As calculated earlier) + ARR from Upsells – Churn ARR

Complete ARR from All Working Examples:

Total ARR = $10,800 + $300 - $300 = $10,800

You could potentially look at ARR by also building in customer acquisition costs (CAC), but in terms of a basic ARR calculation, these are the formulas you need.

Why is Annual Recurring Revenue an Important Metric?

ARR is a fantastic means of understanding the health of your SaaS business. As ARR predicts future revenue, you can measure and forecast growth, plan future investment, and put the necessary focus where you need it, whether that be new customer acquisition, renewing those customers coming to the end of a fixed term contract, upgrading existing customers, or dealing with excessive churn issues.

Let’s look at some of these factors in more detail.

Using ARR to Measure How Well You’re Doing

ARR can help to show you where revenue is growing, where you are losing revenue and customers, and give you an indication as to why. From a wider business perspective, ARR could help you to do everything from measuring the effectiveness of individual employees and departments to increasing workflows and internal efficiency.

Using ARR to Increase Revenue

ARR could help you to understand the best areas to target to increase revenue. You could start to see what the most successful upsells are and get an idea of what customers in specific markets need. In turn this could help you to evolve your approach to sales and marketing, and have a long-term positive impact on your whole business, as well as on your ARR.

Forecasting Revenue

While ARR helps you to forecast the revenue you’re going to get from your current customer base, it can also be useful for forecasting potential revenue from those currently in your sales funnel.

For example, if you sell your SaaS on a B2B basis, and you know that, on average, businesses in the marketing industry spend $10,000 with you and sign a two-year contract, you can forecast ARR of $5,000 for each new marketing business that signs up. 

If you add in your CAC data and conversion rates for your sales team working at acquiring business in this niche, you will soon have a very clear projection not just of future revenue, but what that looks like in terms of the bottom line.

Planning Future Investment

When you have an accurate ARR figure, and a clear forecast of future revenue using the model, you can not only plan how you invest future profits but be in a much better position to go out and acquire external investment. Investors will want to see which revenue is already contractually guaranteed, as well as how much you expect to increase ARR in the coming months and years, and the data that backs all this up.

How Can You Increase Annual Recurring Revenue?

There are four main ways to increase ARR metrics for your SaaS business.

Increasing Customer Acquisition Rates

If you add more customers to your business, they’re going to be paying to use your SaaS platform, and thus your ARR will grow.

Increasing Customer Retention Rates

If you focus solely on customer acquisition, you run the risk of losing customers. If you’re acquiring 10 customers a month with an ARR of $10,000, and losing the same, you’re not growing. ARR growth only comes if you retain your existing business as well as adding new business. When growth is slow, you might be relying on retention to keep your business healthy, so make it a focus immediately!

Increasing Incremental Revenue Through Upsells

It’s easier to upsell to an existing customer than it is to make the equivalent revenue from a new customer. The cost of upselling to an existing customer will be significantly less than the cost of acquiring a new one and onboarding them to your SaaS platform, too.

Reducing Your CAC

Look at your CAC both alongside and independently to your ARR. What can you do to reduce your CAC? If you factor CAC into your total ARR calculation, reducing this will improve your ARR, but even if you don’t use it in your calculation, a reduced CAC is a great outcome anyway, so long as it correlates with continued customer retention and spend rates.

A Real-Life Example of Annual Recurring Revenue with Amazon Prime

In the United States, Amazon Prime costs $12.99 per month, and has a reported 101 million members.

Some of these will be paying annually, but for the purposes of this example let’s assume all Amazon Prime members pay monthly.

Amazon’s basic ARR for their Prime membership in the United States is therefore ($12.99 x 101,000,000) x 12 = $15,743,880,000.

Nearly $16billion in ARR from one market. That would be nice, wouldn’t it! In addition, Amazon also reports that Prime members spend $1,300 a year on buying goods on the site, which equates to a further $131.3billion that could be treated as ARR, depending on the internal ARR definition and calculations Amazon uses.

ARR vs MRR: What is MRR?

Whereas ARR is annual recurring revenue, MRR is monthly recurring revenue.

MRR is useful for looking at trends in more detail, and can show you the instant impact of things like price changes, new tier or product additions, and whether you have seasonal trends around when users sign up or upgrade, or cancel or downgrade.

We’ve taken a closer look at MRR here.

How to Work with Annual Recurring Revenue in Upodi

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