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.