Annual Recurring Revenue (ARR): Definition, Calculation, and Strategies for Growth

Annual recurring revenue (ARR) is defined as the amount of predictable, recurring revenue that a company receives on a yearly basis. ARR tells you your total revenue based on annual subscriptions and subscription renewals for your product or service. It is an especially applicable metric for subscription-based businesses that lock customers into a year contract (or some other recurring billing cycle). For companies with predictable recurring revenue, ARR can be used to forecast revenue as well as company growth.

ARR vs MRR: What’s the difference?

Monthly recurring revenue (MRR) is a metric that shares a lot in common with ARR. Both are a measure of recurring revenue, with the only difference between the two being the timeframe during which the recurring, predictable revenue is calculated. However, there are differences in how these two metrics are utilized as well.

Calculating MRR requires tracking the recurring revenue that a company receives over the course of a month. This metric is used to monitor short-term revenue trends and analyze customer churn. ARR, meanwhile, offers a broader perspective on a company's annual financial outlook.

ARR is a highly important metric for subscription businesses, and calculating your company’s ARR is one of the biggest keys to evaluating its financial position.

For companies with a subscription-based business model, ARR is a metric that directly impacts other vital SaaS metrics such as expansion revenue, future revenue, cash flow, and profitability. ARR is also a pillar stone of a SaaS company’s valuation and a key indicator of future growth/the company’s ability to attract new customers.

Some of the other short-term and long-term benefits of tracking ARR include:

1. ARR provides a measurable indicator for growth. Tracking ARR can tell you a lot about where your company is heading and is an insightful indicator of future growth.

2. ARR enables the forecasting of future revenue. For subscription-based businesses, future revenue is often highly predictable. By tracking ARR, SaaS companies can make more accurate projections of what the company’s future revenue will be.

3. ARR assists in setting realistic goals. It’s important to set financial goals that are challenging yet achievable. Tracking ARR helps SaaS companies determine what qualifies as a realistic goal.

ARR reflects the overall health of a subscription business. ARR is one of the most significant metrics for a SaaS company and is a metric that can provide a lot of insight into a company’s overall financial health.

Now that we’ve discussed the importance of ARR for a subscription business, let’s take a detailed look at how ARR is calculated.

To get started, you will need to add up all of the recurring revenue for your business. The total amount of revenue from yearly subscriptions will likely be the bulk of this figure. However, it is also important to consider subscription revenue sources such as add-ons and upgrades. Keep in mind that ARR is only a measure of predictable, recurring revenue, meaning that any one-time fees/setup fees should not be considered. Revenue lost due to cancellations and downgrades, however, is something you will need to subtract from your annual subscription revenue.

While how all of these figures are measured will ultimately depend on several factors, including whether you have a top-down ARR model or a bottom-up ARR model, the ARR formula remains the same:

Total Number of Customers x Average Annual Contract Value = Annual Recurring Revenue

It’s worth mentioning once again what should and should not be included when calculating average contract value. Any expansion revenue generated via add-ons or upgrades should be factored into contract value, while one-time or variable fees should not.

If you are already tracking monthly recurring revenue (MRR), then you can easily use that metric to calculate ARR with this formula:

MRR x 12 = ARR

Either of these formulas can be used to tell you your company’s ARR and all the important insights this metric has to offer. To further clarify how ARR is calculated, though, we’ve provided a hypothetical example:

ARR calculation example

Let’s say that Company X is a subscription-based SaaS company that wants to calculate its ARR. The company starts by determining the average value of an annual contract, taking into account factors such as upgrades and add-ons but ignoring the one-time setup fee that the company charges new customers. Adding all of these up, Company X determines that its average annual contract value is $3,600.

Company X has 2,500 subscribed customers, so to calculate ARR the company would multiply this number of customers by the average contract value of $3,600 to reach an ARR of $9 million per year. Having calculated its ARR, Company X can now use this metric to project its growth rate, evaluate its financial health, and perform a variety of other assessments.

For any company with a subscription model, increasing ARR is a vital business goal. If you would like to grow your company’s recurring revenue, here are four strategies you can employ.

Optimize your customer acquisition process

The most straightforward way to grow ARR in a SaaS business model is to attract more new customers. By optimizing your customer acquisition strategy, you can grow your company’s ARR metric without having to find ways to increase average contract value. Of course, it’s important to optimize for customer acquisition cost (CAC) as well; while CAC won’t affect ARR, it will certainly affect your company’s profits. 

Encourage upgrades, cross-sells, and upsells

Along with increasing the number of customers you attract, the second way to grow ARR is to increase your average contract value. Optimal pricing is one important factor when it comes to maximizing contract value, and we’ll talk more about that later. Encouraging upgrades, cross-sells, and upsells, however, is another effective way to increase average contract value.

Prioritizing upgrades, cross-sells, and upsells in your sales strategy enables you to get as much value as possible out of each new customer that you attract, directly growing your company’s ARR.

Improve customer retention to minimize churn

Attracting new customers isn’t easy, and it usually isn’t cheap either. Once you’ve managed to add a new customer to your recurring revenue, the last thing you want to do is lose them.

Efforts to improve customer retention and reduce cancellations may very well be the most impactful thing that your company does when it comes to growing annual revenue. By prioritizing customer satisfaction and continuing to deliver value to your recurring subscribers, you can ensure that your ARR only goes up and never drops due to increasing customer churn rates.

Review your pricing and packaging strategies

Determining the right pricing strategy is a crucial decision for any SaaS company. While you want to get as much value as possible from each contract, you also have to set a price that won’t hinder your customer acquisition efforts. In many cases, creating multiple pricing packages that are broken down into tiers based on their price and features is the best way to meet the needs of both your budget and your customers. However you choose to go about it, though, optimizing your pricing strategy for both contract value and customer acquisition will be key to growing ARR.