Let’s talk about annual recurring revenue (ARR).
Have you noticed within the past 10 years you found yourself with more and more subscriptions?
Some of them you had no idea that you still had…
Well, businesses that operate on a subscription model need to make decisions based on their projected revenue for the year.
That’s one of the reasons to track ARR.
So in this article we’re going to define annual recurring revenue, explain how to calculate it and give you some real world examples.
Let’s start with defining ARR:
What is Annual Recurring Revenue (ARR)?
Simply put, annual recurring revenue is the total amount of revenue (money earned before costs) for a subscription-based product or service calculated on a 12 month time frame.
It’s common to see this metric used to predict the future revenue for a gym based on it’s current membership levels. Or when businesses want to measure their yearly revenue for a product or service they offer as a subscription.
Common businesses that use ARR (Example):
- Netflix
- Hulu
- Apple Music
- Spotify
If you wanted to invest in your business it’s helpful to know how much money you’re expecting to make by the end of the year. That’s why you need to know ARR.
The value of a subscription business relies on growing the annual recurring revenue because that’s how you make hiring and expansion decisions.
Let’s move on to figuring out how to calculate ARR.
How to Calculate ARR
We’re going to calculate ARR with some examples.
- You’re selling a software subscription plan. It costs $40 per month. Take the $40 and multiply it by 12 (one year) and you have annual recurring revenue. This one customer contract is worth $480.
- You launch an online course worth $5,000 and offer an installment plan worth $416 per month. Your monthly recurring revenue would be $416 per customer and the annual recurring revenue is $5,000 per customer.
Here’s the simple equation to calculate ARR:
ARR = (Cost of Product or Service) x (# of customers) x (12 Months)
More about this metric
If you were selling a business or buying a business one of the easiest ways to estimate the value of the business is to find out it’s current annual recurring revenue. Because at a minimum a business is worth as much as it’s open contracts.
To find the exact value of a business you would need more numbers like:
- Cost
- Churn rate
- Assets
- Liabilities
But at the very least you want to know the value of “predictable” revenue that a business has.
In general as a business owner you want to track the yearly trend of subscriptions and cancelations. Year over year your subscriptions should be growing at a steady pace that way your business consistently continues to grow without huge influxes of new customers.
Annual Recurring Revenue (ARR) is useful to see the health of a business and to help plan the growth. A business without a monthly or yearly recurring revenue stream needs to save money and plan in shorter windows.
Recurring revenue allows a business owner to see how much money they’re going to have years in advance. So they’re able to invest more confidently knowing money will be there in the future. While tracking ARR it’s important to also look at the lifetime value of a customer.
Not every customer will stay for the entire contract. For example, if you know that the average lifetime value for your subscription service is 3 months, you can plan marketing campaigns to keep customers longer. The longer you can keep a customer engaged in your business then the higher you ARR will grow.
Wrapping This Up
Understanding ARR is a small piece of the larger business puzzle. Don’t let all the jargon in business hold you back from getting started and taking action.
All of these business metrics we measure is to understand our business on a deeper level. But nothing will help our businesses thrive more than hustling and making sales.
If you focus on those two things then everything else seems to usually take care of itself. If you need any help at all with launching your first business don’t hesitate to send us an email.
There’s a whole team here with the resources to answer any question you have.
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