Does your business charge clients regularly (like every month or year)? If so, it's helpful to know about Annual Recurring Revenue (ARR). This represents the total amount of money your company expects to get from its customers over an entire year. It helps you predict how much money you'll make, plan for the future, and see how well you're doing overall.
Monthly Recurring Revenue (MRR) is similar. As the name suggests, it's the amount of money your company expects to get in just one month. While MRR is helpful for short-term planning, ARR gives a bigger picture of how your company is doing and how much it might grow.
For subscription-based business models, ARR shows how valuable your customer relationships are and whether your business model is working well.
Before you crunch the numbers, consider the following factors that affect ARR:
Here's the ARR formula:
For example, if a company has 100 monthly subscriptions at $50 per month and 20 annual subscriptions at $500 per year, the ARR calculation would be:
Monthly Subscriptions ARR = 100 × $50 × 12 = $60,000 Annual Subscriptions ARR = 20 × $500 = $10,000 Total ARR = $60,000 + $10,000 = $70,000
One-time fees are generally excluded from the annual calculation, and there are a few compelling reasons why:
This doesn't mean that one-time fees aren't important. Just track and report them separately, as they significantly contribute to your company's overall revenue and cash flow.
New ARR represents the annual recurring revenue generated from new customers acquired during a specific period. For example, if you sign up 10 new customers in a month, each paying $100 per month, your New ARR for that month would be $12,000 (10 × $100 × 12).
Expansion ARR is the additional recurring revenue generated from existing customers who upgrade their subscriptions or purchase additional services. For instance, if an existing customer paying $100 per month upgrades to a $150 per month plan, the Expansion ARR would be $600 ($50 × 12).
Reactivation AR is the recurring revenue regained from customers who had previously canceled or downgraded their subscriptions but have reactivated their accounts. If a customer who used to pay $100 per month cancels and later reactivates their subscription at the same rate, the Reactivation ARR would be $1,200 ($100 × 12).
Contraction AR refers to the loss of recurring revenue due to customers downgrading their subscriptions or reducing the number of seats or usage. If a customer paying $200 per month downgrades to a $150 per month plan, the Contraction ARR would be -$600 (-$50 × 12).
Churned AR is the loss of recurring revenue from customer churn—customers canceling their subscriptions entirely. If a customer paying $100 per month cancels, the Churned ARR would be -$1,200 (-$100 × 12).
Net ARR is the net change in ARR over a given period, considering all the components mentioned above. It's calculated as follows: Net ARR = New ARR + Expansion ARR + Reactivation ARR - Contraction ARR - Churned ARR Net ARR provides an overall picture of the company's ARR growth or decline during a specific period.
Here's a simple example to illustrate these components:
The Net ARR for this month would be $5,400 ($6,000 + $1,200 + $1,200 - $600 - $2,400).
| Definition | time scale | includes non-recurring rev? | GAAP Metric? | |
| ARR | Annualized value of recurring revenue from subscriptions | Annual | No | No |
| MRR | Monthly value of recurring revenue from subscriptions | Monthly | No | No |
| REVENUE | Total income earned from all business activities | Varies | Yes | Yes |
| BOOKINGS | Total value of contracts signed, regardless of when revenue is recognized | Varies | Yes | No |
The Generally Accepted Accounting Principles (GAAP) metric is a set of standardized accounting rules used for financial reporting. Annual recurring revenue isn't a GAAP metric for several reasons:
Tracking the annual value of all active subscriptions helps you make informed decisions that drive sustainable growth.
Subscription businesses can forecast revenue, evaluate growth strategies, identify upsell opportunities, analyze churn, and plan resources. Your company can make data-driven decisions to optimize growth, minimize churn, and allocate resources effectively.
Annual subscription data can reveal the impact of pricing on customer acquisition, retention, and expansion. If you analyze by pricing tiers, you can see optimal price points that balance your growth and profitability.
Try experimenting with pricing strategies and measuring ARR changes to maximize revenue and customer lifetime value. And if you regularly review and adjust pricing based on ARR insights, your company will remain competitive and better align with your customers' expectations.
By analyzing ARR churn and expansion rates, you can pinpoint successful strategies and areas your business can improve upon. You'll have a better picture of where to upsell and cross-sell based on ARR data. This helps you expand revenue from your existing customers and drive long-term growth.
Investors look at ARR to evaluate the potential and health of subscription businesses. Higher ARR growth rates and lower churn rates demonstrate a strong business model and market fit. By presenting ARR metrics and growth projections, you can attract investors and secure more funding.
ARR data can help identify areas for operational improvement and cost optimization. By analyzing ARR per employee, you can gauge their productivity and efficiency. And if you compare ARR growth to customer acquisition costs and customer lifetime value, it'll reveal opportunities for your team to streamline sales and marketing efforts.
ARR churn rates can highlight areas where operational issues may be impacting customer retention. You can use ARR insights to optimize how you allocate resources, automate processes, and better support customers.
ARR helps you pinpoint key customer segments and regions with high potential. Examining your annual growth rates and the cost of acquiring customers in different markets helps identify expansion opportunities. This information allows you to adjust your pricing and customize your marketing to better suit each market's preferences.
Clearly, ARR is a useful tool that drives your business forward. Still, it comes with challenges and limitations.
For one, not all of your revenue is going to be recurring, so this metric doesn't give you a complete picture of how much you earn. It doesn't include one-time fees or non-recurring income, so you must track total revenue as well.
You're also assuming constant renewal rates, but the reality is that these can fluctuate. Your customers won't always continue to renew their subscriptions at the same rate. Be sure to analyze your past renewal rates and customer behavior and regularly update your forecasts based on actual renewal data to improve accuracy.
And because you're calculating ARR based on the assumption that contracts will last a full year, segment your ARR by contract length. Break down ARR into groupings based on contract lengths (like monthly, quarterly, and annual).
Track the timing of your customer payments and monitor your cash flow closely because ARR doesn't account for payment timings. It represents the total value of contracts but doesn't consider when you'll get your money. As a result, you might have a high ARR but still face cash flow issues if you have delayed or spread out payments.
Lastly, calculating ARR relies on having accurate and up-to-date data on customer contracts and subscription changes. If data tracking is inconsistent or incomplete, your ARR figures might not be reliable. To solve this, make sure you're working with a reliable billing and revenue management system. Regularly review and reconcile your ARR data to correct any discrepancies, and invest in the right automation tools to make your job easier.
By implementing these strategies, you can enhance the reliability and usefulness of ARR as a metric. It's a great way to see how your business is doing, and it helps you predict the financial trajectory of your subscription-based company.
Want to see how a robust accounting system helped one organization strengthen customer relationships and financial stability? Check out PINATA's success story with Tabs.