Ok, I’m no more of a fan of convoluted math than you are, so you can imagine my chagrin when I knew I’d need to talk about how to calculate ARR values. Because, as is so often in situations like this, the professional view of how to calculate something like this is way overblown and convoluted. Seems like this week, I’m combatting quite a lot of this sort of convolution with these metrics.
As with others, there is actually a very simple solution for how to calculate ARR, but before we get to that, we need once more to define the term just for general principle.
ARR, or annual recurring revenue, is the yearly repeating monetary value of a customer on a contract a year or multiple years in length. Obviously, if your contracts are monthly, ARR can still be calculated in retrospect, but it’s less helpful for forecasts in that scenario.
But, most higher end services are on year or longer contracts, so ARR is something you’ll want to know how to calculate.
Truth be told, it’s such a simple thing if you use the easiest method, which means we’re going to have ample time to talk about what this metric is so useful for after I tell you how to calculate it.
So, a customer on a contract of four years for a sum of four thousand dollars total, plus expenses of seven hundred for support and training (a one time cost there) is a good example. When calculating the ARR for each year of his four year contract, you ignore the additional one time costs. Those mostly cover overhead anyhow.
You simply divide the total contract value by the number of years, so four thousand dollars divided by four, giving you an ARR of one thousand dollars per year for them. You will deal with far less even and simple numbers, of course, it’s just best for clean, even numbers during an explanation like this.
Now, why this is so important is because as you plan the duration and cost of the types of contracts available, being able to forecast ARR for potential customers under different models in this remark helps you get solid revenue with a price customers can tolerate.
It also helps you to track the cost of churn, and the value of renewal, which are equally important metrics for a host of other reasons.
A final caveat though about calculating this, and weighing cumulative results is that it is in fact best to compartmentalize the different sizes and costs of contracts, and then calculating the ARR of each different kind, before doing a final summary calculation. Otherwise, your number is going to be all fuzzy and less concrete than it ought to be.
So, when you just use old fashioned super basic arithmetic, the key to how to calculate ARR is surprisingly simple. The more complex models for calculating this, and measuring its ramifications in the real world only act so complex to justify excessive overanalysis of this simple metric. Still, it is an important metric, so I am glad we got this covered, so in the future, you know how to handle it without excessive complexity.