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How to Calculate ARR and Common Challenges: A Comprehensive Guide

By April 25, 2023May 22nd, 2024No Comments

Annual Recurring Revenue (ARR) is a critical financial metric that helps subscription-based businesses determine their revenue over a given year. ARR directly impacts revenue forecasting, customer retention, and a company’s overall growth strategy. However, calculating ARR can be challenging, and the wrong approach can lead to inaccurate results. In this article, we will cover how to calculate ARR, common challenges, and best practices to ensure accuracy.

What is ARR?

ARR refers to the annualized revenue generated by a business from its customers’ subscription payments. This does not include one-time payments, such as implementation or setup fees. As such, ARR is the sum of the annual subscription revenue from all active subscribers, minus any discounts or refunds.

Common Challenges Calculating ARR

While calculating ARR may seem straightforward, there are several common challenges that businesses may face, including incorrect data inputs, inconsistent data sources, differences in revenue recognition practices, and changes in pricing or packaging. These challenges can impact the accuracy of ARR calculations, which can incorrectly steer key business decisions.

The most common issue behind inaccurate ARR calculations is simply human error. Someone fat fingering a subscription start or end date can mess up ARR calculations very easily.  

Additionally, because there are multiple objects that can house ARR data – Opportunities, Contracts, and Invoices, companies need to define their system of record and tie the information together for reconciliation purposes – which is not an easy thing to do given that these objects can live in multiple systems – the CRM, Invoice System, etc.

Furthermore, every company needs to define rules for how to treat various retention scenarios. Common scenarios include how to treat customers you churn but win back within a certain time frame or when to consider a customer churned versus just a late renewal. Now, when a company changes these rule definitions, it is very difficult to go back and update the historical data – namely because the reference data required was not captured (such as how many days late did the account renew). 

Lastly, it’s important to ensure that your ARR data is up-to-date and accurate. If your data is not up-to-date, it can lead to inaccurate forecasting and decision-making. It’s important to have a process in place to regularly review, validate and update the ARR data inputs, such as customer counts and revenue streams. To help this process, businesses should consider investing in systems and tools that automate ARR calculations and reporting. Doing so not only will save time, but it will also reduce the risk of human error.

For more information on common ARR challenges and advice, check out a recent interview conducted with Discern’s Chief Data Scientist, Ling Lin.

How to Calculate ARR?

To calculate ARR, you need to first determine the total amount of revenue that your business expects to generate from its recurring revenue streams over the next 12 months. This can include revenue from subscription-based services, annual contracts, and other recurring sources of income.

  1. Identify your recurring revenue streams: Determine which revenue streams are considered recurring, such as subscription fees, maintenance contracts, or licensing agreements.
  2. Determine the contract value: For each recurring revenue stream, determine the total contract value, which is the total amount that the customer has committed to pay over the course of the contract term.
  3. Adjust for discounts or cancellations: If any discounts or cancellations are expected over the course of the contract term, adjust the contract value accordingly.
  4. Add up the recurring revenue streams: Sum the total contract values for all recurring revenue streams to determine the total expected revenue over the next 12 months.
  5. Bonus Step – MRR: If you want to calculate your MRR (monthly recurring revenue), take the recurring revenue stream amount and divide by 12.

For example, let’s say a company has three recurring revenue streams:

  • $10,000 per month from a subscription service with a 12-month contract term
  • $5,000 per month from a licensing agreement with a 24-month contract term
  • $2,500 per month from a maintenance contract with a 6-month contract term

To calculate the ARR for this company, you would:

  1. Identify the recurring revenue streams: Subscription service, licensing agreement, maintenance contract
  2. Determine the contract value: $120,000 for the subscription service, $120,000 for the licensing agreement, $15,000 for the maintenance contract
  3. Adjust for discounts or cancellations: None expected
  4. Add up the recurring revenue streams: $255,000
  5. (The MRR would be $255,000/12 = $21,250)

In Conclusion

While ARR is a key metric for subscription-based businesses, it should not be the only one tracked. Other important metrics include monthly recurring revenue (MRR), customer acquisition cost (CAC), customer lifetime value (CLTV), and churn rate. Tracking these metrics alongside ARR can provide a more comprehensive view of a business’s overall performance and help identify areas for improvement.

Nevertheless, calculating ARR is a critical KPI for any business looking to measure its revenue growth. By understanding the nuances of ARR calculations and being mindful of the common challenges that can arise, businesses can ensure that their ARR data is accurate and reliable, and can use it to make more informed decisions about growth strategies.