What is ACV and How Does It Compare to ARR?

ACV, or Annual Contract Value, is the average amount of money a customer pays your business each year for their subscription. It’s a key metric for understanding how much revenue you can expect from each customer on a yearly basis.

Annual Contract Value differs from Annual Recurring Revenue (ARR), which is the total amount of money your business earns from all your subscription customers in a year.

Both ACV and ARR are significant for your subscription-based business because they help you predict how much money you’ll make in the future. They also give you a clear picture of your business’s health and growth potential.

Think of it this way: If your ACV is high, it means each customer is paying you a good amount of money every year. And if your ARR is growing steadily, it shows that you’re adding more customers and expanding your revenue streams.

Understanding ACV and ARR can help you make financially sound decisions about pricing, marketing, and customer retention strategies to keep your business thriving.

Understanding Annual Contract Value

The thing to remember is that it focuses on individual customer contracts, not your entire customer base. It looks at the value of each agreement separately, typically over a fixed period of one year (hence the “annual” in ACV).

So, why is this such an important metric for your subscription-based business? It helps you measure the health and potential of your customer relationships. By understanding the average value of your contracts, you can make informed decisions about how to acquire, retain, and grow your customer base.

For example, if you know your annual contract value is $1,000, you can use that information to make decisions. With this, you can set revenue targets, plan your sales strategies, and allocate your marketing budget effectively. Track changes in the annual value of your individual contracts over time to see if customers are upgrading to higher-value plans. If not, you may need to adjust your pricing or packaging.

ACV also helps you predict your revenue more accurately. Since it calculates the value of your contracts over a fixed period, you can use it to forecast how much money you’ll make from your existing customers in the coming months or quarters. 

Overall, ACV is a foundational metric for subscription-based businesses because it provides a clear, consistent way to measure the value of your customer relationships. 

How to Calculate 

To calculate your annual contract value, you need to know two things:

1. The total contract value (TCV) of a customer’s subscription
2. The length of the contract term

Once you have those two pieces of information, you can use this simple formula:

ACV = TCV / Contract Length (in years)

Example 1

Imagine you have a customer who signs up for your software at a rate of $150 per month on a three-year contract.

• Step 1: Calculate the TCV. TCV = Monthly Subscription Rate × Number of Months in the Contract. TCV = $150 × 36 months (3 years × 12 months per year). TCV = $5,400
• Step 2: Divide the TCV by the Contract Length. ACV = TCV / Contract Length (in years). ACV = $5,400 / 3 years ACV = $1,800

In this example, the customer’s ACV is $1,800. This means that, on average, you can expect to earn $1,800 per year from this customer throughout their three-year contract.

Example 2

Suppose another customer signs up for an annual plan at $2,000 per year.

In this case, the TCV is already expressed in annual terms, so the ACV is simply equal to the TCV:

ACV = TCV (when the contract is already in annual terms) 

ACV = $2,000

Note that you can calculate ACV differently depending on your business model and pricing structure. For example, if you offer monthly subscriptions without long-term contracts, you might calculate ACV by multiplying the monthly rate by 12 to get the annual value.

The takeaway is that ACV helps you normalize the value of your customer contracts over a consistent period (usually a year) so you can make apples-to-apples comparisons and informed business decisions.

Considerations for Multi-Year Contracts

When including or excluding one-time fees in the first year of multi-year contracts, there are a few important considerations.

To clarify the term, one-time fees are typically one-off charges that a customer pays at the beginning of their contract, such as setup fees, onboarding costs, or implementation charges. They’re separate from the recurring subscription fees that the customer pays throughout the term of the contract.

When calculating ACV, you have two options for handling these one-time fees:

1. Include the one-time fees in the TCV and calculate ACV as usual. If you choose this approach, you’ll add the one-time fees to the TCV before dividing it by the contract length to get the ACV. This method gives you a slightly higher ACV in the first year, but it also provides a more accurate picture of the total value of the contract.
   
   Suppose a customer signs a 3-year contract at $1,000 per year, with a one-time setup fee of $500. The TCV would be $3,500 ($1,000 × 3 years + $500), and the ACV would be $1,167 ($3,500 / 3 years).
    
2. Exclude the one-time fees and calculate ACV based only on recurring revenue. Alternatively, you can choose to exclude the one-time fees from your ACV calculation and focus solely on the recurring subscription revenue. This approach gives you a more consistent ACV throughout the life of the contract, but it may understate the total value of the deal.
   
   Using the same example, if you exclude the $500 setup fee, the TCV would be $3,000 ($1,000 × 3 years), and the ACV would be $1,000 ($3,000 / 3 years).

Deciding on which approach depends on your business goals and how you want to communicate the value of your contracts. If you want to emphasize the total value of each deal, including one-time fees in your ACV calculation may make sense. But, if you want to focus on the predictable, recurring revenue from your customers, excluding one-time fees may be the better option.

In short, be consistent in your approach and clearly communicate your methodology to stakeholders. This way, everyone is on the same page when discussing and analyzing your ACV metrics.

ACV vs. ARR

ACV

ACV is a customer-level metric that measures the average annual value of a single customer contract. It takes the TCV of a customer’s subscription and divides it by the length of the contract in years. ACV helps you understand how much revenue you can expect from each customer on an annual basis based on their specific contract terms.

For example, if a customer signs a two-year contract for $2,400, their ACV would be $1,200 ($2,400 / 2 years). ACV is useful for analyzing the value of individual customer relationships and predicting revenue from specific contracts.

ARR

ARR is a company-level metric that measures the total recurring revenue your business generates from all your customers over a year. It’s the sum of all your customers’ annual subscription fees, excluding any one-time charges or variable fees.

To calculate ARR, you take the monthly recurring revenue (MRR) from all your customers and multiply it by 12. For instance, if your business has 100 customers paying an average of $100 per month, your MRR would be $10,000, and your ARR would be $120,000 ($10,000 × 12 months).

ARR gives you a high-level view of your business’s overall recurring revenue stream instead of focusing on individual customer contracts like ACV does.

Key Differences

• ACV is a customer-level metric, while ARR is a company-level metric.
• ACV measures the average annual value of a single customer contract, while ARR measures the total recurring revenue from all customers over a year.
• ACV helps you analyze individual customer relationships, while ARR gives you a big-picture view of your business’s recurring revenue.

Implications on Business Strategy and Financial Analysis

When it comes to shaping your business strategy, ACV and ARR work best together.

Strategic Decision-Making

ACV helps you understand the value of your customer contracts, which can inform things like pricing and packaging decisions. If your ACV is too low, you may need to adjust your pricing tiers or add more value to your offerings to increase the average contract size. But, if your ACV is high, you might consider expanding your customer base with more affordable plans to attract a wider range of users.

Also, ACV and ARR can help you set sales targets and allocate marketing resources effectively. When you know your typical contract value and total recurring revenue, you can create realistic goals for your sales team and invest in marketing channels that are most likely to attract high-value customers.

Finally, ACV and ARR highlight the importance of retaining your existing customers. Since these metrics focus on recurring revenue, any customer churn will directly impact your bottom line. Monitoring ACV and ARR helps you prioritize customer success initiatives and proactively address any issues that may lead to cancellations or downgrades.

Financial Forecasting and Analysis

ACV and ARR are crucial inputs for creating accurate revenue forecasts. By multiplying your average ACV by the number of new customers you expect to acquire, you can project your future revenue growth. Similarly, ARR helps you establish a baseline for your recurring revenue and understand how changes in your customer base will impact your overall financial performance.

These metrics also help with valuation and fundraising. Investors often look at ACV and ARR when evaluating the potential of a subscription-based business. A high ACV suggests that you’re able to generate significant value from each customer, while a growing ARR indicates that your business has a stable and predictable revenue stream. 

Tracking your ACV and ARR can help you make informed decisions about how to allocate your resources. For example, if your ACV is high but your sales cycle is long, you may need to invest more in sales and customer support to maintain those valuable relationships. Similarly, if your ARR is growing rapidly, you might prioritize investments in infrastructure and product development to keep up with demand.

Real-World Applications of ACV

Assessing Sales Performance

By tracking the average contract value for each sales rep or team, you can identify top performers and areas for improvement. For example, if one sales rep consistently closes deals with a higher ACV, you can analyze their techniques and share best practices with the rest of the team. Conversely, if a rep’s ACV is consistently lower than average, you may need to provide additional training or resources to help them sell more effectively.

Customer Retention and Resource Allocation

By segmenting your customers based on their ACV, you can identify your most valuable accounts and make sure they receive the highest level of support and attention. This might include dedicated account managers, personalized onboarding, or priority access to new features and upgrades.

Additionally, you can make data-backed calls on where to invest in product development, marketing, and other areas of your business. For instance, if a significant portion of your revenue comes from enterprise customers with high ACVs, you may want to focus on building features and integrations that cater to their specific needs.

Forecasting and Financial Planning

When you multiply your average ACV by the number of new customers you expect to acquire in a given period, you can project your revenue growth and make informed decisions about budgeting, staffing, and other investments.

Moreover, tracking changes in ACV over time can provide valuable insights into the health and trajectory of your business. If your ACV is consistently increasing, it may indicate that you’re successfully moving upmarket and attracting more valuable customers. But, if your ACV is declining, it could signal a need to reassess your pricing strategy or improve your product’s value proposition.

Challenges and Considerations

While ACV is an incredible tool for your business, it’s not always smooth sailing. Calculating and using ACV effectively comes with its own set of challenges. 

Variability in Contract Terms

When calculating ACV, you may see some wild variability in contract terms. It’s like trying to compare apples to oranges. Contracts can differ a lot in terms of duration, payment structures, and one-time fees. This contract chaos leads to inconsistencies in your ACV calculations, making it difficult to compare ACVs across various contracts or customer segments.

Picture this: You have one contract that’s three years long with a hefty upfront payment and lower annual fees and another with evenly spread-out annual payments. Trying to compare the ACVs of these two can throw off your perception of customer value if you’re not careful, and that can lead to some seriously wonky strategic decisions.

Consistency in Calculations

Keeping your ACV on the straight and narrow means establishing some standardized methods for calculating it. Without clear guidelines, you might have different teams calculating ACV in their own particular way, and that can cause confusion and unreliable data. You don’t want to be making big decisions based on numbers that don’t add up.

Advice for Maintaining Consistency

Here are some tips to help you maintain consistency and keep your metrics on point:

1. Create an ACV Calculation Playbook: Develop and document a standard formula and guidelines for calculating ACV. Decide upfront whether to include one-time fees, how to handle multi-year contracts, and any other considerations that are specific to your business.
2. Train Your Team: Make sure everyone who’s involved in calculating and using ACV is on the same page. Regular training sessions and documentation can help keep everyone in sync and consistent across the board.
3. Keep It Fresh: Your ACV calculation methods might need an update from time to time. Periodically review and revise your procedures to reflect any changes in your business model or market conditions. 
4. Automate It: Consider using software tools that automate ACV calculations according to your standardized policies. Not only does this reduce the risk of human error, but it also guarantees that your calculations are consistent every single time.

Concluding Thoughts

By now, you’ve seen how this powerful metric sheds light on the annual value of your contracts, giving you the insights you need to make smart decisions about where to focus your time, energy, and resources.

But ACV works best when paired with other financial metrics like ARR. Together, they create a comprehensive picture of your company’s financial landscape, helping you navigate the ups and downs of running a successful business.

Putting this metric to work starts with making it a central part of your business strategy. You can forecast your revenue with greater accuracy, evaluate your sales team’s performance, and retain your high-value customers. It’s all about prioritizing the contracts that matter most and aligning your efforts to maximize your revenue potential.

Managing B2B contracts and streamlining your accounts receivable process can be a challenge, but that’s where Tabs can help. Our AI-powered platform simplifies contract management and automates the AR process, giving you the tools you need to boost your cash flow and drive sustainable growth. By integrating Tabs into your financial strategy, you can take your ACV analysis to the next level and unlock new opportunities for success.