What is ARR (Annual Recurring Revenue) & how to calculate it?

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June 20, 2023
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What is ARR (Annual Recurring Revenue) & how to calculate it?

Subscription-based businesses benefit from a fairly predictable and reliable revenue stream, which is great for forecasting, planning, and even attracting investors.

But in order to really make the most of this enviably stable source of income, you need a way to understand it. That’s where Annual Recurring Revenue comes in. It allows you to transform your subscriptions into a veritable goldmine of useful data, and offers insights into everything from customer churn to strategic performance.

In this article, we’ll explain what ARR is, how to calculate it accurately, how to optimize it, and how Checkout.com can benefit your subscription business.

What does ARR mean in finance?

Annual Recurring Revenue (RRR) measures the predictable and recurring revenue your company receives from its customers every year in exchange for products and services. Or, in other words, it’s the total sum of all revenue generated from subscription fees over a 12-month period. ARR is most commonly used by subscription-based businesses.

Some businesses also used monthly recurring revenue (MMR), which essentially produces the same data but on a monthly basis.  

How to calculate annual recurring revenue

There are a number of ways to calculate ARR, but the first thing to know is that you should only use your recurring revenue in your sums. Any one-time charges or variable fees should be discounted as they’re not classed as recurring or predictable, and would produce an incorrect result.

To get an accurate picture of your ARR, you’ll also need to factor in some other figures and deductions, including:

  • ARR from new customers
  • ARR from existing customer renewals
  • ARR from existing customer upgrades (someone moving up to a more expensive plan)
  • ARR lost from existing customer downgrades (moving to a less expensive plan)
  • ARR lost from customer churn (cancellations)

So, a simple annual recurring revenue formula is the sum of all your annual recurring revenue and upgrades minus lost revenue from downgrades and cancellations. Here’s an example:

  • You have 3 existing customers who each have an annual subscription valued at $100 per year = ARR $300
  • In the same year, you gain 2 new customers = ARR $200
  • And one of your existing customers upgrades to the $150 plan
  • So your total ARR for the year is $550

However, let’s say one of your customers cancels their plan, and another downgrades to the $50 plan, meaning you lose $150 that year. That would leave you with an ARR of $400.

Another way to work out your ARR is to use the same method to calculate your MMR and then multiply that figure by 12. You can also take the total figure for your multi-year contracts and divide the total contract value by the number of years.

Why is the annual recurring revenue important for a subscription business?

Tracking and understanding your ARR is vital for determining the current and future performance of your business, and can be used to inform key strategic decisions.  

Here’s why ARR is important for subscription businesses:

  • Forecast and increase your revenue - by working out your ARR, you can forecast your expected revenue deferred over the coming year. Although you can’t predict variables like cancellations with absolute accuracy, the predictability of subscription-based income gives you a pretty reliable picture of your future takings and is a useful baseline for working out more complex calculations. For example, you can take your ARR and factor in potential price changes, the impact of marketing, or customer churn. You can also gain useful insights into customer behavior, including which customer segments are your most valuable, which can inform cross and up-selling and boost your revenue
  • Has the potential to result in very high valuations - predictable, contract-based income is a real advantage when trying to woo investors, who can be confident that your financials are accurate and reliable
  • Evaluate company health and performance - ARR gives you a pretty comprehensive picture of the health of your business, showing where and how you’re losing and gaining revenue. This data is invaluable when deciding on what course of action will be most impactful. For example, should you prioritize customer acquisition? Or focus on upselling upgrades to your existing ones?

Read more: What is unearned revenue?

How to optimize your ARR

Here are some simple ways subscription businesses can optimize their ARR:

  • Gain more customers - customer acquisition is vital to the growth of subscription-based business models. The more customers you have, the higher (and healthier) your ARR
  • Increase revenue with upgrades and value-based pricing - acquisition alone isn't enough. You should incentivize your customers to upgrade to higher price point plans by demonstrating that there is genuine value to be gained from doing so
  • Keep customers to maximize their lifetime value - don’t be so consumed by customer acquisition that you forget to focus on your existing customers - retention is just as important. A happy, loyal customer with a multi-year contract is at low risk of churn, which is good for your ARR
  • Cut customer acquisition costs - you should also optimize your customer acquisition strategy. Your approach shouldn’t be to gain customers at all costs, it should be to gain them in the most efficient and cost-effective way possible  

What is the difference between ARR and MRR?

MMR is simply ARR but calculated on a monthly basis. ARR is a macro metric, allowing you to see the performance of your business year-on-year, which is great for long-term planning and forecasting. It’s especially useful for businesses that tend to have customers with multi-year contracts.

MMR gives you a more granular insight into the month-on-month performance of your business, which is useful for measuring the immediate impact of changes to, for example, your pricing strategy. It’s also a better metric for businesses that rely on shorter-term subscription lengths of less than a year. MMR allows you to respond quickly and decisively to sudden or periodic fluctuations in revenue, helping you to overcome challenges and provide a great customer experience.  

Subscriptions solutions with Checkout.com

If you’re a subscription-based business, Checkout.com has all the tools you need to optimize performance and growth.

We understand that your success depends on delivering a consistent and reliable service. That’s why we give you a simple and secure way to manage and process subscription payments. With payment integrations, it’s easy to update or cancel recurring payments, while our payments API enables fast processing and a smoother customer experience. What’s more, by supporting a host of popular global payment methods, you're empowered to target growth across every international market.

Finally, we give you access to all the data and reporting you need to track your performance and make confident strategic decisions.

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June 20, 2023 10:54
June 20, 2023 11:12