Annual recurring revenue (ARR) and annual contract value (ACV) are crucial metrics to understand in the software as a service (SaaS) business, as it tells them how much of their business is recurring.
ARR (Monthly Recurring Revenue x 12 months) not only calculates the business revenue in a one-year period but also helps to gauge the size of the business, predict future revenue, and measure overall growth. However, ARR can be inaccurate due to seasonal spikes that can result in overstated or understated estimates.
This is where ACV (Total contract value/contract period in years) comes in handy. It normalizes the revenue across one or more years per customer contract.
If this sounds confusing, rest easy. SalesWorks has been in the sales industry for over 25 years, and having dealt with innumerable reports and calculations, we’ve simplified matters for you in this article for easier understanding.
Calculating ARR and ACV
You have three hypothetical customers:
- Customer 1 pays $50,000 per year for 1 year
- Customer 2 pays $40,000 per year for 2 years
- Customer 3 pays $30,000 per year for 3 years
To calculate the ACV, we take the total contract value (TVC) and divide it by the total years in each contract. If there are multiple clients, make sure to only include the contracts which are active for that year.
In the first year, all three clients are paying and their contracts are active.
Year 1: ($50,000 + $40,000 + $30,000) / 3 = $40,000
The ACV for Year 1 is $40,000.
In Year 2, customer 1 is no longer on the contract, therefore we exclude them from Year 2’s ACV.
Year 2: ($40,000 + $30,000) / 2 = $35,000
The ACV for Year 2 is $35,000.
In Year 3, only Customer 3 remains.
Year 3: $30,000 / 1 = $30,000
Calculating the ARR is simpler in the sense that no dividing is required here. Just total the revenue made in the year and subtract the losses. Using the example before, let us calculate the ARR for Year 1. Add the payments made that year together.
Year 1: $50,000 + $40,000 + $30,000 = $120,000
Your ARR for Year 1 is $120,000.
In Year 2, we only need to calculate the two remaining customers on the contract that year.
Year 2: $40,000 + $30,000 = $70,000
Your ARR for Year 2 is $70,000.
Lastly, only one customer is left on the contract in Year 3.
Year 3: $30,000 = $30,000
Your ARR for Year 3 is $30,000.
When calculating ARR, note that the following factors should be considered as well:
- Product upgrades
- Product downgrades
- Add-on purchases
- Cancellations (Churn)
Therefore, a more thorough formula for ARR is:
ARR = ARR at the beginning of the year + ARR gained from new customers + ARR gained from product upgrades + ARR gained from add-on purchases – ARR lost to product downgrades – ARR lost to cancellations/customer churn
ARR vs ACV
ARR works to calculate what your business already has, but in order to take your business to where you want it to be, ACV needs to be combined with other metrics (such as Total Contract Value (TCV), Customer Acquisition Cost (CAC), and Annual Recurring Revenue (ARR)) to be extremely useful.
ARR on its own is handy as it helps you calculate year-over-year growth. It is also a momentum metric that many businesses can track on their own.
So, who needs ACV and ARR?
People who can benefit from these key metrics include:
Year-over-year ARR comparisons can be used to improve the projections and timing around:
- Acquiring new staff
- Large capital expenditures
- Company valuation
- Annual budgets
When it comes to timing a new capital contribution, ARR can help you judge when would be the best time to make the decision.
Sales managers and executives
Pairing ARR with ACV can help you:
- Make more profitable decisions and recommendations
- Keep track of your team’s performance
- Adjust your training efforts accordingly
Using CAC in conjunction with ACV is beneficial here to compare the value of your accounts against the cost of acquiring them. From there, you can adapt your strategies, spend your finances, and use your resources better.
Image: Clay Banks
ACV can help you estimate and keep track of your annual sales revenue, examine your customer base, and notice which accounts you need to pay attention to when the time comes.
When accounts are close to the end of their term, you may want to:
- Negotiate to extend the contract
- Suggest an add-on product or service
- Execute a customer retention strategy
Grow your sales and business with SalesWorks
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