What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue (ARR) estimates the predictable revenue generated per year by a SaaS company from customers on either a subscription plan or a multi-year contract.
ARR—or Annual Recurring Revenue—is the industry-standard measure of revenue for SaaS companies that sell subscription contracts to B2B customers, whereby the plan is active in excess of twelve months.
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How to Calculate Annual Recurring Revenue (ARR)
ARR stands for “Annual Recurring Revenue” and represents a company’s subscription-based revenue expressed on an annualized basis.
While not a GAAP metric, the annual recurring revenue (ARR) metric measures a SaaS company’s historical (and future) operating performance more accurately than the revenue recognized under accrual accounting standards.
The annual recurring revenue (ARR) reflects only the recurring revenue component of a company’s total revenue, which is indicative of the long-term viability of a SaaS company’s business model.
In practice, the ARR is the primary KPI used to measure the health of SaaS and other subscription-based companies with business models oriented around recurring revenue and multi-year contracts, particularly for forecasting year-over-year (YoY) growth.
Since ARR represents the revenue expected to repeat into the future, the metric is most useful for tracking trends and predicting growth, as well as for identifying the strengths (or weaknesses) of the company.
Annual Recurring Revenue Formula (ARR)
The annual recurring revenue (ARR) metric is a company’s total recurring revenue expressed on an annualized basis.
Conceptually, the ARR metric can be thought of as the annualized MRR of subscription-based businesses.
The formula to calculate the annual recurring revenue (ARR) is equal to the monthly recurring revenue (MRR) multiplied by twelve months.
The ARR metric factors in the revenue from subscriptions and expansion revenue (e.g. upgrades), as well as the deductions related to canceled subscriptions and account downgrades.
In order to properly calculate the metric, one-time fees such as set-up fees, professional service (or consulting) fees, and installation costs must be excluded, since they are one-time/non-recurring.
For example, let’s say a customer negotiated and agreed to a four-year contract for a subscription service for a total of $50,000 over the contract term.
To calculate the ARR of the SaaS provider on this particular customer, we would divide the contract value ($50,000) by the number of years (4), which comes out to an ARR of $12,500 per year.
- Annual Recurring Revenue (ARR) = $50,000 ÷ 4 Years = $12,500
What are the Full-Form Components of ARR?
There are a total of six components to annual recurring revenue (ARR), which must be analyzed to truly understand the underlying growth drivers and customer engagement rates.
- New ARR ➝ New ARR is the revenue earned from new subscriptions
- Expansion ARR ➝ Expansion ARR is the revenue earned from subscription upgrades (upselling, cross-selling, product bundling).
- Renewal ARR ➝ Renewal ARR is the revenue earned from existing subscription renewals.
- Churned ARR ➝ Churned ARR is the revenue lost from canceled subscriptions.
- Contraction ARR ➝ Contraction ARR is the revenue lost from downgraded subscriptions
- Reactivation ARR ➝ Reactivation ARR is the revenue earned from customers that had cancelled their subscription in the past, but decided to re-subscribe.
