Annual recurring revenue (ARR) is a financial metric showing the total revenue generated from annual subscription sales.
Companies with contract terms exceeding a year prefer the ARR metric. Software (SaaS) companies and subscription businesses commonly use this calculation. Typically, businesses with annual revenue exceeding $10M use ARR to track yearly subscription sales instead of monthly recurring revenue.
How Do Companies Calculate ARR?
It’s a straightforward calculation. Take the total contract value and divide it by the length of the contract period.
If a subscriber agrees to a three-year contract for $45,000, the ARR would be $15,000.
ARR only includes fixed fees associated with the annual subscription or contract. Similar to MRR, this metric does not consider one-time fees or charges.
In all cases, this metric won’t be equal to or greater than all the revenue generated in a year. That’s because ARR only includes revenue from subscription sales. Again, the calculation does not include one-time fees or charges.
The most common question about calculating this metric is how to handle billing cycles. However, the billing cycle shouldn’t affect the calculation if the contract is longer than a year and recorded on the same schedule.
Only include contracts longer than a year in your calculation. It’s better to use the MRR calculation for contracts shorter than a year.
Why Is ARR Important for Businesses?
This metric is invaluable. It represents a critical aspect of your business’s annual revenue and helps identify future revenue and growth opportunities.
A clear understanding of ARR and MRR allows subscription-model businesses to choose short- and long-term goals for predictable revenue. It also provides a clear demonstration of product-market fit.
ARR allows businesses to track the underlying increases or decreases in annual subscriptions as follows:
Increase in ARR: An increase in this metric is typically reported in two categories:
- New ARR: New annual recurring revenue added to the year, driven by new subscribers or contracts. When calculating this new revenue, removing any churned customers is essential.
- Recurring Add-on ARR: This type of revenue results from upselling or cross-selling products and services.
Decrease in ARR: Tracking decreases in this metric involves evaluating your company’s churn rate. Customer churn happens when customers either decrease their annual service level or cancel their services altogether.
How Can Predictive Analytics Support ARR Goals?
Predictive analytics is a great tool to help you meet and exceed ARR goals and improve other important metrics. With predictive analytics, companies can predict key factors influencing annual recurring revenue. A few of the most common predictive methods that support your goals are:
- Increase your customer base: The best way predictive analytics supports ARR goals is by supporting acquisition strategies and driving new subscribers. Conversion rate modeling powered by predictive analytics allows businesses to build audience look-alike segments and score leads. These models typically result in higher conversion rates and more qualified prospects engaging with your sales team.
- Prioritize upsell/cross-sell opportunities: Predictive analytics for upsell/cross-sell is one of the best ways to boost the key metric of ARR. Predicting when customers will likely buy a complementary product or upgrade their service will provide expansion revenue. It will also improve CAC payback periods and loyalty initiatives.
- Predictive customer churn: Predicting customer churn is an excellent way to get ahead of declining annual recurring revenue. Predictive churn software can help detect 85% of customer churn and improve retention rates by as much as 35%.
If you’re looking to get started in predictive analytics, we created a helpful guide. The guide leads you and other stakeholders through gathering information and making decisions about your data-driven strategy.
If you are interested in how Pecan AI can support your business, contact us or schedule a demo.
