Annual Recurring Revenue (ARR) And How to Calculate It

The concept of recurring revenue has been around for a long time. For example, service retainers paid to lawyers or consultants or the expectation of continued purchases of specific products from loyal customers of big brands. Many new recurring revenue models have arisen in the last decade for both tangible and intangible products, including SaaS providers. The popularity of subscription businesses has made annual recurring revenue (ARR) a very important financial metric.

In this article, you will learn about annual recurring revenue and how it differs from revenue and monthly recurring revenue. You will also learn about some popular recurring revenue models, as well as how to calculate annual recurring revenue (ARR).

What is Annual Recurring Revenue (ARR)?

Recurring revenue is the income made from subscriptions or contract services. When calculating annual recurring revenue, the revenue from the company’s subscriptions is normalized for the year. For example, a single three-year subscription for an amount of $6000 results in an ARR of $2000.

Examples of Annual Recurring Revenue

There are many possible types of recurring revenue models, from massive brands that can count on a loyal customer base to keep purchasing their products to SaaS providers that sell yearly subscriptions to their services.

1. Brand or Product Loyalty

This model has been around for quite some time but is only really an option for well-known brands with loyal customers. Companies like Coca-Cola or Pepsi have a more than reasonable expectation that their customers will make future purchases.

However, companies like Apple are known to use additional strategies to ensure recurring income. For example, sunken cost consumables like special chargers, covers, and other accessories, as well as subscription services like iCloud storage or AppleCare.

2. Long-Term Contracts

Contracts are another great source of recurring income. For example, there are annual service contracts that provide a specific number of hours or tasks per week or month.

Cell phone companies are well-known for their long-term contracts and cancellation fees. These fees ensure that if the customer wants to terminate the contract before the agreed date, the company will recover some or all of the lost revenue, depending on the severity of the agreed penalty.

3. Product Subscriptions

These days, it’s possible to subscribe to specific products and establish a delivery schedule. This is sometimes available directly through the manufacturer or through larger retailers.

Amazon, for instance, allows customers to select different quantities of multiple products, as well as how often they should be delivered. In many cases, there is no discount resulting from the subscription, simply the guarantee that you won’t run out of that product.

4. Service Subscriptions

By now, service subscriptions seem to be available for anything you can think of. However, there is no doubt that a great many of them provide services related to software or digital content of some type.

There are many possible models within this category, depending on the type and number of services, whether you pay for use or you pay a flat fee, etc. For instance, streaming services like Netflix or Disney+ offer self-renewing subscriptions, which are automatically charged until the customer cancels. Others provide subscriptions that the customer must renew annually.

How to calculate Annual Recurring Revenue?

How you calculate annual recurring revenue will depend on your business model and the specific products or services you offer. Generally speaking, you need to add the total amount for yearly subscriptions to the total amount gained from expansion revenue, then subtract the amount lost in cancellations.

ARR = yearly subscriptions revenue + expansion revenue - cancellation revenue

Expansion revenue does not include one-off payments, only add-ons or upgrades that affect the yearly subscription cost. The amount lost due to downgrades - switching to a cheaper plan - can be added to the cancellation revenue.

What is the difference between ARR and revenue?

While revenue includes all of your company’s income, annual recurring revenue (ARR) only considers the income generated by subscription services. In other words, while revenue is common to all companies, ARR refers exclusively to income generated by subscription-based services, excluding one-off payments like installation fees.

What is the difference between ARR and MRR?

Annual recurring revenue (ARR) and monthly recurring revenue (MRR) are essentially the same metrics except for the period of time they represent. While ARR is normalized annually, MRR is normalized monthly. This makes MRR more suitable for tracking short-term fluctuations and progress. ARR, on the other hand, provides a long-term view and can be more useful in terms of financial strategy and planning.

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Conclusion

As you have seen, some recurring revenue models have been around for a long time. However, the current dependence on contracts and subscriptions for both products and services has resulted in a wide variety of recurring revenue models. In terms of long-term planning and revenue forecasts, annual recurring revenue is a very useful metric.

You now know about recurring revenue and some of the most popular models available. You also know how to calculate annual recurring revenue (ARR), and how it differs from revenue and monthly recurring revenue (MRR).