ARR vs ACV (Definitions + Formula)
February 23, 2022 Edwin Kooistra
In the professional business industry, ARR and ACV are two acronyms used very commonly. In relevance to the SaaS industry, ARR (Annual Recurring Revenue) refers to how much recurring revenue you can expect in a year based on your subscriptions.
While ACV (Annual Contract Value), more relevant for other sectors in comparison to SaaS, refers to your annual contracted value for your subscriptions, from each customer, normalized for every year.
We should now look at the detailed definitions of both these terms and how we can calculate both. After which, we shall reflect on which one should be your preferred choice as a business owner.
What Is the Definition Of ARR?
ARR stands for annual recurring revenue. This metric shows you the amount of income you are earning in one year from all your combined subscriptions. Annual recurring revenue helps you determine your revenue at any point in time.
It measures the total value (in terms of dollars) of the total income you can expect to earn in a particular year, keeping your current subscriptions in view. It does not consider a one-time processing fee or subscription charge, a typical transaction in the SaaS industry.
As a generally accepted principle, ARR is considered a suitable metric for determining a company’s financial health and revenue growth.
It does not only help you in calculating the projected revenue growth but also highlights possible fluctuations in the revenue stream caused by upselling, cancellations, renewals, etc. It also provides you insights into your marketing and sales strategies based on the analysis of the ARR value.
How to Calculate ARR?
We shall now look at the different ways to calculate ARR for your convenience.
The simplest way you can calculate your ARR to get an overall idea is by using the following formula.
ARR= Total Annual Revenue – Non-Recurring Revenue
This formula calculates ARR by using the value of your non-recurring revenue and subtracting it from your total annual income from the previous year.
Even though this is an easy method, it is not the industry standard. It also does not account for the evolution of customer subscriptions over a period.
Let us now look at the standard ARR formula and understand it further with the help of an example.
ARR = ARR at the start of the year + ARR increased by customer addition + ARR increased from subscription upgrades – ARR decreased due to subscription downgrades – ARR reduced due to customer churn
Let’s assume that at the start of the year, you have 50 customers, with each customer having a recurring revenue value of $1000. If nothing changes over the year, your ARR is $50,000 (50 x $1000). But let us look at some possible scenarios in the year and how they will impact your ARR.
- You gain 10 new customers (10 x$1000= $10,000)
- 5 customers increased their subscription value by opting for the $1200 plan (5 x $200=$1000)
- 3 customers downgrade to the $800 plan (3 x $200 =$600)
- 2 customers cancel their subscription altogether ( 2 x $1000 = $2000)
Now to calculate the actual ARR, we shall put these values in the formula.
ARR = $50,000 + $10,000 +$1000 – $600 – $2000
Annual Contract Value (ACV) is a metric that tells you the actual worth of ongoing customer contracts, normalized and averaged out over one year.
You can use ACV as a reliable metric to measure the value of different customer accounts, whether they are monthly subscriptions, customized plans, and especially multi-year arrangements.
These calculations reflect the recurring revenue you will receive from a single customer, normalized on an annual basis. The value of ACV does not account for one-time subscriptions or set up costs.
As ACV uses a normalizing approach towards the contract value, it helps you compare customers that have contracts with a different matter and time duration. Not only that, but ACV also enables you to identify the most profitable clients, especially those that will have a potential long-term relationship with your company.
How to Calculate ACV?
Let’s now look at the ACV formula and how it can be approached in different ways.
ACV = Total Value of a Contract / Contract Duration in Years
The above mentioned is the formula for ACV when dealing with a single customer or client. For illustration purposes, Client A signs a $3000 contract with you for three years. The ACV will be calculated as:
ACV = $3000/3
ACV = $1000
Another Client B signs a subscription contract of 2 years, valued at $2800
ACV = $2800/2
Looking at the ACV for Client A and Client B, we now understand the role of ACV in sales and comparing customer accounts.
Let us now see how we can calculate ACV across multiple contracts belonging to different customers. This example will further clarify the role of ACV when it comes to comparing different contracts.
Customer A has an ACV of $1000, Customer B has an ACV of $1500 and Customer C has an ACV of $1400
Total ACV = $3900 (Adding all ACVs)
Average ACV = $3900 /3
Average ACV = $1300
In a different example, we shall assume that you have signed different customers with three different contract values and durations, then the ACV in this situation can be calculated for that as well.
- 2 x three year contracts for $6000
- 1 x 2 year contract for $2500
- 3 x 1 year contracts for $1200
Here you will first calculate the ACV for each contract category
- ($6000 /3 )x 2 = $4000
- ($2500/2) x 1 = $1250
- ($1200/1) x 3 = $3600
Total ACV = $4000 + $1250 +$3600
Total ACV = $8850
Now we should calculate the average ACV.
Average ACV = $8850/ Number of Contracts
Average ACV = $1475
What Is the Difference Between ACV vs ARR?
As both the metrics, ACV and ACR, reflects the annualized value of customer subscriptions or contracts, they are often confused. Let us now look at some of the significant differences between ACV and ARR that will help you differentiate between the two.
- ARR measures the value of multiple accounts across one year, whereas ACV measures the value of a single account, averaged across multiple years.
- ARR measure recurring revenue as the total dollar value of subscriptions on an annual basis, while ACV measures the value of a subscription as an average dollar amount normalized over one year.
- ARR never accounts for one-time revenue (set-up cost), while ACV can do so under certain conditions or as per business choice.
- ARR formula is standardized across the SaaS industry, whereas the ACV formula varies from organization to organization.
When Should a Business Consider ARR Or ACV?
Given that both these metrics provide a certain type of insight, choosing to go with one metric at a time depends on industry to industry. For example, in the SaaS industry, ACV alone by itself cannot provide an insightful measure. But when combined with other relevant metrics, it can prove to be powerful.
While you can use an ARR to measure year-on-year growth in terms of revenue, ACV can be used to analyze the effectiveness of your sales strategy and how well are you succeeding at customer attraction and value. Therefore, the choice between the two is subjective, based on a multitude of factors.
Both ARR and ACV are useful metrics that you can utilize within your business setting depending on the industry. These metrics when used appropriately in alignment with your internal structure and market dynamics, will help you in understanding revenue growth and customer success.
Not only this, but they will also reveal tangible insights that you can use to improve your processes and gain an edge over your competitors. These metrics will also play a role in directing customer retention initiatives as well as investment in different marketing tactics. That is why they are important and used across multiple industries by different businesses.