The model you use will depend on your goals and how your business operates financially, but whichever method applies to you, it’s important to know how to properly measure your subscription revenue.
First of all, let’s explore what ARR means and how it works as a model for measuring revenue. ARR stands for annual recurring revenue and applies only to businesses that offer subscriptions on a contracted length. Most SaaS businesses that operate in the public domain don’t use a contract model, meaning customers pay each month and can cancel their subscription at any time without having to worry about being locked in for a set period of time.
For this reason, ARR tends to be a metric used by B2B SaaS businesses, although it is often used by almost all SaaS businesses in important financial meetings in order to give a general overview of how much money is being pulled in from fixed contracts only on a yearly basis. The reason for this is that ARR fits better with other yearly financial reports.
In essence, if your company operates on a B2B basis whereby clients are locked into a subscription contract, or if you’re dealing with a smaller transaction volume but a higher transaction value, ARR might be the metric you choose to measure your financials with.
MRR stands for monthly recurring revenue and is mostly used by B2C SaaS businesses to better understand their monthly finances. For example, this is most likely to be the model companies like Netflix use in order to identify key client metrics on a rolling basis since none of their customers are locked into a contract.
This allows the company to spot potential patterns in monthly users and whether there’s been a rapid explosion of growth or the opposite.
How to calculate ARR
Now you’re familiar with the difference between MRR and ARR for subscription revenue model businesses, it’s time to look at how each one is measured. It’s not quite as simple as just looking at how much money your company earns in a month or a year from subscriptions – there are a number of other things that can be added to your overall revenue stats. First, let’s look at how to calculate ARR.
To correctly calculate ARR, you need to make sure you’re only looking at contracts with a minimum term of one year. If you have contracts that are only three months long, they won’t fit into an ARR model because they won’t provide an accurate overview across a 12-month period. In this instance, adopting an MRR model might be more appropriate.
With this in mind, the majority of B2B SaaS companies offer standard contract lengths of 12, 24, 36, and 48 months so that ARR revenue is easier to measure.
Your SaaS company may provide a monthly service that brings in revenue, but it may also have one-off fees that need to be paid for setting up the service, such as admin fees. These are not paid on a monthly basis because by their very nature are one-time fees. With this in mind, they shouldn’t be included in your ARR calculations because they’re not a main source of income and don’t apply to the whole contract length.
When offering B2B contracts, it’s not uncommon to secure a deal by providing a discount. This is common practice, although it’s something that a lot of companies forget to account for when calculating their ARR metrics. You need to make sure you’re keeping track of all discounts offered as this will affect the overall final figure.
This means when you’re looking at your ARR metrics, only include the price you’re being paid by the client, not the standard price. If they’re not paying the standard rate for a service, don’t put them down for the standard rate. Use the discounted rate as a basis for your calculations.
ARR calculation examples
Now we’re clear on what shouldn’t be included in ARR calculations, it’s time to look at what is. In essence, all you need to include is the total cost for the subscription itself. Other fees and bolt-ons may be accounted for separately so that you’re able to get an accurate idea of what your subscriptions only bring in on an annual basis.
Here are some calculation examples that highlight what should be included in your ARR metrics.
Example 1: A customer signs up for a 36-month subscription service that costs £30,000 in total. Their contract also includes a £10,000 fee for additional training and resources; however, this is not part of the core subscription service and therefore counted as an add-on, despite it taking the total price up to £40,000. In this scenario, the ARR value is £10,000 because that is the cost of the subscription alone on a yearly basis.
Example 2: A customer signs up for a 12-month subscription contract at a cost of £100,000. They must pay a £5,000 one-off admin fee to complete the transaction. The ARR is £100,000 because one-off fees are excluded from ARR calculations as they are not a recurring fee across the 12 months.
Example 3: A customer signs up for a 48-month contract that totals £2,400, but they pay it in monthly instalments rather than in one lump sum. The ARR is £1,200. It doesn’t matter how a subscription is paid when calculating ARR – all that matters is the overall value of the subscription on a yearly basis.
Example 4: A client signs up for a 12-month subscription contract that has a full price value of £10,000, but they’ve got a 20% discount which means they pay £8,000. The ARR is £8,000 because the client is only paying £8,000 per year, even though the full price is usually £10,000.
Another way to look at calculating ARR is by measuring the MRR and multiplying it by 12. This is another common way it’s done because although some companies look at ARR exclusively, it’s handy to know where your business stands on a monthly basis so that you can look closer at covering overheads and managing the day-to-day running of your company.
For example, if your MRR is £2,000, your ARR will be £24,000 because you’re multiplying the MRR by 12 to get the ARR.
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How to calculate MRR
So, we’ve just mentioned that you can use the MRR and multiply it by 12 to get the ARR, but how exactly do you go about getting the MRR? Let’s look at how to calculate MRR for companies that operate on a rolling monthly basis with no minimum contract length.
Put simply, MRR can be easily calculated in the same way as ARR, but on a four-week basis rather than a 52-week basis.
MRR looks exclusively at monthly finances. It does not seek to identify an annual revenue figure, although it can be used to do that if you want to calculate ARR further down the line. Generally speaking, MRR is calculated only when your SaaS company is utilising a monthly subscription model similar to the likes of Dropbox, Spotify, or Netflix.
If you have long-term contracts in place, it’s best to separate those from your monthly ones and calculate them at an ARR rate as that suits the type of contract better and will allow you to make a clearer distinction between your long-term contracts and your short-term monthly earnings.
Much like when you calculate the ARR, you shouldn’t be counting one-off fees and non-recurring fees. As mentioned before, this is because these fees do not directly correlate to the subscription service that is being provided and tend to sit under their own umbrella.
For example, if you earn £10 per month for the subscription but charge a £2 admin fee for the initial account set up, this shouldn’t be included when doing your MRR calculations; it's a one-off cost and isn’t relevant to the product at hand.
It’s not just B2B companies that offer discounts on their subscription services – rolling contract companies do too. You may have seen this in the form of Netflix offering a reduced price for new members for the first six months, or other companies offering six months free. In this case, your MRR is the discounted rate, and if that discount means the service is being provided for free, then this means your MRR would be £0.
MRR calculation examples
To help make it clearer what should and shouldn’t be included in your MRR metrics, here are some examples.
Example 1: A customer sets up a new account and signs up for a no-contract service with your company priced at £50 per month. During their first month, they have to pay an additional £10 so they can get set up and access a free perk/benefit for choosing your service. The MRR is £50 because the set-up fee isn’t recurring and therefore isn’t counted.
Example 2: A person signs up to four of your subscription plans, each of which is priced at £20. The MRR is £80. It doesn’t necessarily matter how many services their subscription is spread over if all the money goes into the same pot; however, you may choose to further break down the MRR for each individual service so you can gauge which is the most popular or which one brings in the least amount of monthly revenue.
Example 3: A customer signs up to your subscription service which is usually priced at £30, but they have a 20% discount which means they pay £24 per month. Although your subscription is usually £30, if the customer isn’t paying this price, this isn’t your MRR. Your MRR is the discounted fee of £24.
Affecting factors for subscription revenue models
Now you have a clearer idea of the MRR and ARR definitions and how they’re calculated, the final port of call is to understand affecting factors for both revenue models. We’ve already spoken about discounts and how they shouldn’t be included, but another thing that needs to be removed is lost customers.
You need to ensure your accounting software is equipped to remove any lost customers as and when they drop off, otherwise you risk skewing your data and not recognising a loss of revenue when it happens.
Another affecting factor you need to include is any upgrades or downgrades. For example, your SaaS company might offer a basic and a premium service, If your customers upgrade or downgrade at any point during the month or during the length of their contract, this needs to be clearly accounted for within your ARR or MRR figures.
Keeping track of your ARR or MRR metrics is a key aspect of ensuring the longevity and success of your SaaS business, and knowing how to calculate each aspect correctly is highly important. The points raised above should aid you in doing so, but if you still need help in keeping on top of your cash flow and bookkeeping, or if you need advice on how to grow your subscription base, the expert Accountancy Cloud team is here for you.
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