Imagine a company sells small-business accounting software, and last year it generated $11 million in revenue. Yearly subscriptions that customers pay to access the software made up $10 million of the total. This amount, which a business can predict with a good deal of certainty, is known as annual recurring revenue (ARR).
Learn more about annual recurring revenue and how your business can use it to help measure growth and guide plans for expansion.
What is ARR?
Annual recurring revenue (ARR) is revenue derived from subscription agreements or other contractual payment agreements of one year or more. Like monthly recurring revenue (MRR), ARR represents a regular, predictable stream of business income.
People use ARR to evaluate the financial health of subscription businesses, including companies that provide cable TV, phone and internet service, electric utilities, software as a service (SaaS), and publications. A subscription business receives routine payments from regular customers in contrast to revenue from one-off sales. Executives rely on ARR’s high degree of predictability for making decisions about spending, budgeting, and expansion. Lenders and investors also use it in considering whether to provide capital.
Uses for ARR
Measuring ARR has several uses for a business, including:
Quantifying growth
ARR is the predictable revenue for a subscription-based company, so measuring it from year to year provides insight into a company’s growth and momentum. Total revenue may fluctuate more because it includes irregular sources. For instance, a company had an ARR of $10 million in the latest year, up from $8 million the previous year. But total revenue was $11 million, with $1 million in sales to one-time customers. You wouldn’t include that $1 million to calculate ARR because it would make the growth comparison appear higher than it really was.
Forecasting revenue
Because ARR is a measure of predictable sustainable growth, it helps a company forecast next year’s ARR. Let’s say the company above has averaged 25% growth in ARR the past two years. It could reasonably forecast the same growth for the current year, barring any unforeseen events that might change the company’s prospects.
Attracting outside capital
Lenders and investors evaluate a company’s ARR when deciding whether to provide capital to support routine operations or expansion. The predictability of ARR gives a level of assurance.
Assessing customer satisfaction
Close monitoring of ARR helps a company assess customer satisfaction based on its retention rate—the percentage of existing customers who continue their annual subscriptions. An increase in ARR can signal high customer retention, while a decline in ARR may indicate lower retention, meaning subscribers are not renewing. A company can use ARR data to seek ways to improve service and boost customer satisfaction.
How to calculate ARR
The most common method to calculate annual recurring revenue starts with determining a business’s last ARR, sometimes called its base subscription revenue, which excludes any one-time or variable revenue sources. Next, identify sources of new annual recurring revenue, as well as any sources of lost annual recurring revenue. These sources are:
New ARR
New ARR reflects the addition of new subscribers to a company’s customer base. This is often the main driver of a subscription business’s growth.
Expansion ARR
Expansion ARR refers to any recurring revenue from existing subscribers who add services to their existing plans. Let’s say a small-business accounting software company offers a $200 extra service for invoicing, billing, and customer collection on top of its $1,000 standard annual subscription. If 50 subscribers sign up for the extra service, expansion revenue is $10,000, or 50 times $200.
Upgrade ARR
Upgrade ARR is an increase in recurring revenue from existing subscribers choosing higher-priced plans. For instance, if 50 subscribers to a standard $1,000 annual plan upgrade to a $2,000 premium subscription, this increases ARR by $50,000, or 50 times $1,000.
Downgrade ARR
The opposite of upgrade ARR, downgrade ARR is the amount of lost recurring revenue due to subscribers opting for lower-priced plans. Should 10 of a company’s $2,000 premium subscribers step down to the $1,000 standard plan, for example, downgrade ARR would total $10,000, or 10 times $1,000 ($2,000 - $1,000).
Churn ARR
Churn refers to a decline in recurring revenue from canceled subscriptions. A company normally wants to minimize churn and downgrade ARR while maximizing new, upgrade, and expansion ARR.
Net new ARR
Net new ARR refers to the sum of revenue from new ARR, plus expansion and upgrade ARR, minus churn and downgrade ARR. The formula for calculating is similar to the MRR formula, except it’s on a full-year basis:
Net new ARR = (new ARR + expansion ARR + upgrade ARR) - (churn + downgrade ARR)
You then calculate total ARR by combining net new ARR with current ARR, sometimes called base annual subscription revenue.
Consider an SaaS company that sells one-year subscriptions to its small-business accounting software. The first table below shows how the company might track its increase in ARR, broken down by sources. The second table shows how net new ARR contributed to growth in its subscriber base—the starting point for forecasting and tracking the next year’s recurring revenue.
| ($ figures in 000s) | January 2023 | January 2024 |
| New ARR (subscriptions) | 200 | 400 |
| Expansion and upgrade ARR | +100 | +150 |
| Churn and downgrade ARR | -50 | -20 |
| Net new ARR | 250 | 530 |
Adding net new ARR to beginning ARR, we calculate ending ARR, which becomes:
| ($ figures in 000s) | January 2023 | January 2024 |
| Beginning (base) ARR | 2,000 | 2,250 |
| Net new ARR | 250 | 530 |
| Ending ARR | 2,250 | 2,780 |
Tips for optimizing ARR
A subscription business can strive to attain more annual recurring revenue by doing the following:
Add subscribers
Building your subscriber base typically starts with developing profiles of potential customers. Your business can focus its marketing efforts on these prospects while tracking how much you spend to entice them, which determines your customer acquisition cost (CAC). Ways to attract new subscribers might include offering a discount or other incentive for an annual subscription, or promoting new or improved features.
Increase upgrades
Increasing upgrades is a cost-effective way of boosting ARR because you have already paid the customer acquisition cost of getting the subscribers. You can spend less in persuading them to bump up to a premium subscription from a standard plan, for example, or buy an additional service to tack onto their current subscription.
Reduce churn
To retain customers, determine what satisfies or displeases them about your service. This may involve going beyond customer satisfaction surveys and contacting subscribers to seek their views. Those expressing satisfaction help to confirm the value of your service, while those who are dissatisfied or ready to cancel their subscriptions give you an opportunity to make improvements or add desirable features. Retaining subscribers boosts your customer lifetime value, or the amount of revenue you can reasonably expect from a customer for the duration of the business relationship.
ARR vs. MRR
Annual and monthly recurring revenue are both based on the same principle and same basic formula: net new recurring revenue plus the recurring revenue from the current subscription base. The two measures, however, involve different time periods and amounts.
ARR includes only revenue that will last for at least one year. MRR may include revenue you receive during shorter periods; for example, you would record a six-month subscription for $600 as MRR of $100 for each month, but none of that revenue counts as ARR.
MRR is the amount a business receives each month that is continuous and predictable based on customer payment agreements such as subscriptions or contracts. Similar to ARR, it doesn’t include revenue from infrequent transactions such as one-time sales of products or services.
Limitations of ARR
Although ARR is a valuable metric for companies that receive revenue from subscriptions or contractual agreements, it has several limitations, including:
Non-GAAP
Because ARR doesn’t comply with generally accepted accounting principles (GAAP), you can’t present it in regulatory financial statements such as an income statement or balance sheet. For example, ARR doesn’t use the widely accepted accrual accounting method, which, among other things, records revenue when sales occur, even if you haven’t collected the money yet.
Cost omission
ARR doesn’t account for costs and, therefore, it provides little information about a company’s efficiency or profitability. Customer acquisition cost, or CAC, is the amount a company spends to sign up a subscriber, which includes free or discounted trial subscription periods. To be profitable, a business aims to maximize revenue from subscribers while minimizing the costs of signing them up. A full income statement is necessary to show whether a company is generating enough revenue to cover customer acquisition costs, as well as any other business expenses.
Retention
The cost of upgrading and cross-selling to current subscribers is typically much less than the cost of finding and signing up new customers. But ARR doesn’t necessarily show how well a business performs at keeping its customers and eliciting more revenue from them versus adding new subscribers.
Annual recurring revenue FAQ
Is ARR the same as revenue?
Annual recurring revenue (ARR) is a form of revenue, but it’s not total revenue because it only reflects the money a business receives from subscriptions or contracts that last a year or longer. It doesn’t include other revenue that is irregular or nonrecurring as a result of one-time sales. A business’s total revenue comes from both recurring and nonrecurring sources.
What is a good ARR?
No single figure makes an ARR good or bad. Much depends on the business’s recent history, its industry, and its costs. ARR, like MRR, is more about momentum: Is ARR growing and at what rate? Or is it stagnant or declining?
What are the limitations of ARR?
The most important limitation is that ARR doesn’t meet generally accepted accounting principles (GAAP), meaning there is no codified way of compiling and presenting results, and it is not acceptable in a company’s regulatory filings. Also, ARR focuses only on top-line growth, not cost management and profitability.
