Annual Recurring Revenue (ARR) is a KPI for subscription-based businesses that show the money that comes in every year for the life of a subscription (or contract).
Annual Recurring Revenue is a critical metric for any business. It measures the net revenue of an organization on an annual basis, taking into account the effects of changes in exchange rates and fluctuations in prices.
Since ARR is a key measure of revenue performance and profitability, it's essential to understand how it's calculated and the factors that affect its calculation. In this post, we'll explore how ARR works and why it matters to you as a business owner.
What is Annual Recurring Revenue (ARR)?
Its primary function is to track the growth of an organization over time. ARR tracks the total money that the business has generated during a period of one year, regardless of when it was generated. This metric also tracks how profitable the business has been, taking into regard all costs associated with bringing in revenue.
ARR helps show how well your company is performing financially by measuring annual revenue generated from all sources. It allows you to evaluate your success against other companies in your industry and helps you benchmark your performance over time.
Why is ARR Important?
ARR is a critical metric for any business, measuring the net revenue of an organization on an annual basis. ARR accounts for the effects of changes in exchange rates and fluctuations in prices, making it more valuable than just looking at gross revenue.
For example, you have spent considerable time and money bringing your product to market. Once it's ready, you would like to know how much profit you're generating on that product.
How do you calculate ARR?
To calculate ARR, subtract the cost of goods sold from the monthly revenue. This will give you a monthly profit or loss per unit sold. Then, divide that monthly profit by the total number of units sold. The result is your average profit per unit for each month of operation.
The formula for ARR is fairly simple: divide the cumulative revenue by the date of acquisition. The key point to note is that this metric does not reflect any change in the value of inventory or depreciation expenses.
In other words, it's a snapshot in time. If you want to calculate ARR with these factors taken into account, you'll need to use a metric like net present value (NPV).
We know from our previous article on NPV that it takes into account future cash flow and adjusts for changing exchange rates and prices. This means that NPV will give a better picture of how your company is performing financially rather than just showing you a snapshot in time.
Your accountant can help with estimating your ARR if you're not calculating it yourself.
Factors Affecting ARR
It's important to understand the factors that affect ARR so you know what to watch out for.
For example, revenue fluctuation due to changes in exchange rates can distort ARR calculation. The fluctuations may not be consistent or even predictable, so they may not be reflected in the numbers. When this happens, it throws off your ROI percentages and other important metrics.
The changing price of goods and services also affects how much revenue is generated by a business over the course of a year. Even if your business is generating $100,000 per year, that number might change depending on whether you're experiencing inflation or deflation during that time period.
This means that an item that cost $10 at the beginning of the year might cost $11 by the end of it—even if your business never sold another one. This can lead to inaccurate ARR calculations and make it difficult for you to assess the profitability of your company on an annual basis.
One of the most important factors in calculating ARR is exchange rates. Exchange rates are the fluctuation in value between two currencies.
For example, if the U.S. dollar's value goes up against the Euro, then it would be cheaper to buy Euros with USDs. However, if the US dollar's value decreases instead, then it becomes more expensive to purchase Euros with US dollars.
The effect of these changes on your business depends on where your company generates revenue and has expenses. For instance, if you generate revenue only in one country or region, then any change in exchange rates will affect your ARR. If you have expenses in different countries or regions across the globe, then ARR will be affected by changes to all of those currencies as well as any changes specific to one country or region.
If you use a service that takes care of exchange rates for you (like Xero), then this won't affect your ARR calculation because it can adjust accordingly for any fluctuations in value across currencies.
Prices of goods sold
The first factor that affects an organization's ARR is the price of goods sold. The higher the price, the more revenue will be generated. Hence, if you sell your products at a higher price, then your ARR will increase.
This means that if you have a product priced at $100 and someone bought it, your ARR would be $100. Now, let's say you have the same product that is now priced at $200. If someone also buys this second product, then your ARR would be $200.
The important thing to note here is that this calculation does not take into account any discounts or promotional offers available to customers for buying more than one product.
Cost of goods sold
The cost of goods sold is the raw materials that are used to produce your product or service. If you're a software company, this might be the cost of developing the code for your project. If you're a retailer, this could be the cost of purchasing inventory.
If you want to determine your ARR, you'll need to know how much it costs to produce your product or service and how much revenue you generate from selling it. You subtract the cost of goods sold from the revenue generated by selling it and that's one component of ARR.
Your ARR will vary based on how much material was required to produce what you're selling and how much you charge for it. For example, if someone sells $10 worth of ice cream for $5 each, they may not make any money on the ice cream itself because they spent so much time making it (raw materials). On the other hand, if somebody makes $100 worth of customized artwork and charges $500 per piece, their raw materials would be about $0 because they can't reuse them after they sell them (not reusable).
Repairs and maintenance costs
The costs to maintain and repair a business' infrastructure, such as buildings or equipment, can have a significant impact on ARR.
For example, let's say your building is in need of repairs. This could be from wear and tear from regular use, an earthquake, or another natural disaster. These repairs will have to be done eventually, but the timing will affect your ARR.
You might decide to put off repairing your building until next year because you want to see how much revenue you're going to bring in this year before spending money. In this scenario, if you wait until next year to do these repairs, your ARR for this year would not be correct because it doesn't include the cost of the necessary repairs.
Similarly, if you make a major purchase early in the year that will add significant revenue for the rest of the year but comes with a high upfront cost (such as buying a new delivery truck), then your ARR calculation will show an inflated value for this year and an artificially low value for next year because it won't take into account the full purchase price and the increased revenue generated by that purchase.
ARR (and MRR – monthly recurring revenue) is a very important metric for any business. It tells you the total revenue generated over the course of a year, all multiplied by the frequency of customer renewals. As you can see, ARR plays a large role in both the success and sustainability of your business.
To calculate ARR, you will need to know how much revenue you generate over the course of a year, how many customers you have, and the length of your customer’s contract (the frequency of renewals). Once you have these numbers, divide them to calculate your ARR.
Then, determine whether or not your ARR is good enough to sustain your business. This can be done by comparing your ARR to your total revenue. If your ARR is less than 20% of your total revenue this could be problematic.
If your business is not sustaining, then it may be time to take a look at what you are doing to generate revenue—especially if you are not generating any ARR.