Last editedApr 20233 min read
Of all metrics to follow, the annual recurring revenue calculation should be top of the list when you sell subscriptions. Learning how to calculate annual recurring revenue ensures your business is on the right track in terms of financial forecasting and strategy. Find out the key components you need to use this formula, as well as a few tips to optimize your figures over time.
What is ARR in business and why is it important?
Annual recurring revenue, or ARR, is used primarily by subscription-based businesses. This metric shows the amount of revenue a company can expect to receive from customers from one year to the next. This revenue is generated from contracts, subscriptions, or any other recurring billing cycles. While monthly recurring revenue (MRR) shows monthly growth, ARR in business shows year-on-year growth.
So, how is this helpful for businesses? As with similar metrics, tracking ARR gives you a clear idea of your business’s financial health and projected growth. This helps with decision making down the road. Will you have the incoming revenue necessary for expansion or product development? You’ll be able to map out business growth over time and track any changes. At the same time, ARR is a useful baseline figure for financial forecasting. It’s useful to compare this metric with others like customer churn to get a realistic overview of company health.
What is the annual recurring revenue formula?
Any calculation starts with the basic annual recurring revenue formula:
ARR = (Subscription revenue for the year + recurring revenue from upgrades or add-ons to existing subscriptions) – (Revenue lost from cancellation, downgrades, and churn)
Of course, if you already calculate monthly recurring revenue, a simpler annual recurring revenue formula is:
ARR = MRR x 12
How to calculate annual recurring revenue
The easiest ARR calculation method is to multiply MRR by 12 months. MRR is simple to work out by multiplying your average revenue by customer by your total number of active customers for that month.
For example, imagine that your company has 10 subscription customers. Five of these are paying for your basic tier of service at $40 per month while the other half are paying the premium rate at $80 per month. That means the average revenue per customer is $60, making your MRR $600. Multiply this by 12 and your ARR is $7,200.
The second ARR calculation method is a little more complex, but it’s also more accurate as it takes all the year’s extra charges, upgrades and downgrades into account. You use the formula above which subtracts any revenue lost from cancellations and downgrades from the total recurring revenue generated through annual subscriptions, upgrades, and add-ons.
The base figure you’ll need is your customer revenue per year, along with product and account add-ons, upgrades, and downgrades. You should also consider any lost revenue from customer churn.
Annual recurring revenue calculation example
Here’s a breakdown of how this formula works with a quick annual recurring revenue calculation example.
Imagine that Company ABC offers three pricing tiers, like many subscription businesses.
A customer starts the year with the Basic plan and keeps it for four months before upgrading to Premium. They stick with the Premium package for the remainder of the year and renew for next year.
Total $ of yearly subscription: $8 x 12 months = $96
Total $ added through Premium upgrade: $4 per month for remaining 8 months = $32
Total $ lost through downgrades or cancellations: $0
ARR = $128
This shows how you can calculate the ARR for each active customer, factoring in any upgrades or downgrades to subscription services. For company-wide ARR, you’ll need to add in all subscription activity including various account levels, cancellations, upgrades and downgrades throughout the calendar year.
How to improve your annual recurring revenue
Ideally, ARR should show year-on-year growth of SaaS recurring revenue. If this isn’t happening and you’re experiencing high levels of customer churn, it’s time to shift your approach. One tactic is to focus on customer acquisition through new advertising campaigns and sales. Of course, a common statistic is that it costs five times more to acquire new customers than to retain existing ones.
Customer retention is a better use of resources in many cases. Break your customers down into individual buyer personas and find ways to improve your product according to pain points. Focus on upselling your existing subscriptions by offering discounts for annual renewal and other incentives.
Finally, take care that you’re not losing revenue through involuntary churn. This happens when a customer’s payment details expire or are entered incorrectly without their knowledge. GoCardless offers an intelligent retries service called Success+ that optimizes the timing of payments, successfully collecting 70% of payments that fail the first time around. Set up ACH Pull through GoCardless to control payment timings and amounts. You’ll be able to collect recurring payments directly from customer bank accounts without hassle, reducing churn and improving ARR as a result.
We can help
GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.