ARR (Annual Recurring Revenue): Business Meaning and Definition

Patrick Ward Patrick Ward Follow May 13, 2021 · 7 mins read
ARR (Annual Recurring Revenue): Business Meaning and Definition

Business Definition of “ARR”

The acronym “ARR” stands for “Annual Recurring Revenue”. In other words, ARR is your Revenue from recurring payments, annualized. The formula for ARR is:
ARR = (Subscription Cost Per Year + Recurring Revenue From Upsells and Upgrades) - Revenue Lost from Cancellations or Churn.

What is the formula for ARR?

To calculate Annual Recurring Revenue, simply divide the total contract value by the number of years. For example, if a customer signs a two-year contract for $8,000, divide $8,000 (the total contract value) by two (number of years) for an ARR of $4,000 per year.

While Annual Recurring Revenue is relatively easy to calculate, it is very important to remember that ARR only includes contractually obligated revenue, not one-time revenue from late fees, add-on services or special purchases.

The goal with ARR is to determine what revenue can be assured for the purposes of financial projects. If revenue that is not guaranteed through contracts or subscriptions is included, the business may believe it has more reliable revenue than it does and may overspend as a result.

What Does “ARR” Mean?

Annual Recurring Revenue, or ARR, is a subscription performance metric that shows the revenue anticipated every year over the life of a subscription or contract.

In other words, Annual Recurring Revenue represents the anticipated, annualized revenue from a company’s current subscriptions and contracts. Revenue that is not contractually obligated to the company, such as service fees, are not counted in this metric.

With that in mind, ARR can be used to measure the health of a subscription-based business, such as a Software as a Service company, by measuring the revenue on which the company can rely over the course of the year.

Additionally, Annual Recurring Revenue can be helpful as a relationship measurement tool. Since subscription commitments can indicate the relationship customers have with your product, their willingness to agree to an ongoing relationship may be an indicator of their confidence in your brand or satisfaction with your brand. Conversely, a high number of customers who prefer non-contractual interactions may indicate that they require an additional “nudge” to commit to your service financially.

ARR is commonly combined with “projected” and used to make revenue sound higher than it is. For example, a SaaS product that makes $10 in its first month and $50 in its second month is experiencing exponential 500% growth. Projected ARR is a million dollars.

Usage

ARR is commonly used as a metric by SaaS companies and their founders. Within the Indie Hackers community, it is a common metric used when presenting success of a project.

While ARR is not a generally accepted measurement in Accounting (it is unlikely to be seen in a financial audit or a profit and loss statement prepared by an accounting firm), it is a measurement that is important for business and financial professionals to understand.

Business managers, investors, analysts, entrepreneurs, and financial reporting staff, especially those working in service as a subscription-based businesses and Software as a Service companies, should be familiar with this performance indicator.

Understanding ARR

With the rise of online businesses, which may offer a combination of short and long-term subscriptions, one-time purchases, free introductory offerings, and other programs, it can be difficult for companies to develop a clear picture of their financial well-being. Annual Recurring Revenue, or ARR, is a performance metric that helps quantify the revenue generated on an annual basis exclusively from contracts and subscriptions. This understanding is necessary because, while expenses like personnel costs are often constant, income can be widely variable — especially in industries in which one-time purchases can spike due to economic factors and social trends. Basing decisions, such as company acquisitions and staffing expansion, on reliable revenue will help companies make safer business choices.

Recurring Revenue can appear through different channels depending on the industry and consumer expectations. For example, in some business sectors, companies may still be able to require multi-year contracts. This contractual expectation can still be found with cell phone contracts, home security agreements and automobile leases. Often, the length of the contract is necessary for the business to recoup up-front expenses from product installations, or to allow a consumer to spread out the cost of a hardware purchase to make the investment more accessible. These companies have a reliable income base, as along as new contracts are continually signed.

However, modern consumers are less interested in long-term contracts and pay-as-you-go models are more appealing to customers with unpredictable cash flow, as well as those who are simply experimenting with a new opportunity. This change in consumer expectations has placed many subscription businesses at a disadvantage, encouraging them to look toward shorter contract durations, lower cost subscriptions, and add-on services. As a result, it can be difficult for many businesses to establish a steady revenue base on which to make decisions, or to understand their future revenue well enough to make wise decisions.

However, Annual Recurring Revenue is a business metric that shows how much ongoing revenue can be expected based on yearly subscriptions and provides subscription-based companies with a clearer picture of organizational health. For example, if a subscriber purchases a one-year subscription for $500, but chooses to purchase additional add-on services, the ARR for that consumer is $500, since the company can feel confident planning on receiving that contractually-obligated money.

Annual run rate vs annual recurring revenue: what’s the difference?

Annual Recurring Revenue is a success metric that depicts the revenue that comes in every year over the duration of a subscription or contract. Since many contracts or subscriptions still operate on an annual basis, this is the most reliable indicator of financial health for many companies, including Software as a Service businesses.

However, some businesses utilize subscriptions of a shorter duration, or some are entirely dependent on month-to-month revenue, such as restaurants and retail establishments. Also, in some instances, the business is very new and may need to make assumptions about future growth using very limited data.

In those cases, Annual Run Rate may be used. Annual Run Rate can be determined by extrapolating information from a unit of time and annualizing it. For example, a new restaurant that makes $3,000 in January and February, may be able to assume an ARR of $36,000 ($3,000 a month, multiplied by twelve months).

That said, it is important to choose a timeframe that would be representative of overall business performance when calculating Annual Run Rate. Failure to do so, may result in inaccurate data and poor financial decisions.

Moreover, businesses that can adopt, or at least incorporate, annual subscriptions into their sales model may find that their revenue picture becomes easier to understand and more reliable to predict.

Is ARR higher than revenue?

When calculating Annual Recurring Revenue, we would not typically expect the total to be higher than revenue, overall. This is because the revenue considered in ARR is specifically subscription or contract based. Other revenue, such as one-time purchases and late fees, are not considered in Annual Recurring Revenue – though they are still important to consider from a profit and loss standpoint.

With that in mind, when calculating Annual Recurring Revenue, we would expect to find a lower dollar figure than that of overall company revenue.

Is ARR calculated from net or gross revenue?

Annual Recurring Revenue is calculated using gross revenue from contracts and subscriptions.

What is the difference between ARR and revenue?

Revenue encompasses all categories of money received by the company during business. That can include subscriptions, late fees, one-time sales, donations, tips, purchases from special promotions and other money generated from consumers, government programs and corporate partners.

However, much of this revenue may not be predictable and, unless supported by extensive history and financial analysis, might be unreliable for financial decisioning.

Annual Recurring Revenue removes all revenue that is not contractually obligated from its equation, and calculates only annualized, guaranteed revenue from subscriptions and contracts.

Patrick Ward
Written by Patrick Ward Follow
Hi, I'm Patrick. I made this site to share my expertise on team augmentation, nearshore development, and remote work.