What Are They? And How to Calculate Them
SaaS businesses face the heat of stiff competition, and to cut through it, they need the right arsenal. Since nothing can beat the leverage correct data would give you, it’s critical to get this part right.
But when every other entrepreneur has come up with their own metrics, which ones should you follow and which ones should you forget?
In this article, we will dive deep into the two most popular revenue metrics to get your business on track.
What is ACV?
Annual Contract Value, or ACV, is the average or normalized contract value of a client using your subscription for a year.
You can calculate ACV for all customers irrespective of whether they are on a monthly or quarterly plan and have varying plan values.
How to Calculate ACV?
To calculate ACV, you will need the following data.
Total Contract Value (TCV): It’s the total revenue you get from customers, including one-time charges.
One-time Fees: These are any charges the customers pay only once and are not part of their recurring subscription fee. It could be training, integration, or setup charges.
Contract Term Length: It’s the duration of the contract in years
What Are the Benefits of ACV?
1. Focus on High-Value Clients
With ACV, you can compare the clients to invest in more promising contracts for better returns.
2. Analyze Pricing Model
You can understand which contract and pricing model provides you with the maximum benefits.
3. Optimize Resource Allocation
Once you discover the true potential of your clients, you can allocate relevant resources to bring in more business from them.
What is ARR?
Annual Recurring Revenue, or ARR, is the total of all recurring income you have received from your customers.
Keep in mind to exclude the one-time costs while calculating the ARR. It’s a great indicator of a company’s financial health.
How to Calculate ARR?
It’s pretty straightforward to calculate the ARR. All you have to do is add up the monthly revenue coming from the customers through the subscription fee.
To calculate annual recurring revenue, multiply your monthly recurring revenue by the number of months in a year. Exclude the one-time subscription costs here.
What are the Benefits of ARR?
1. Track Yearly Growth
ARR gives more visibility to the company’s year-on-year growth. You can easily track your revenue graph over the years to deduce whether you are in profit or loss.
For example- You can set a revenue target and use ARR as a go-to metric to analyze if you are on the right track to achieve the goal or not.
2. Revenue Forecast
You can segregate your revenue stream to forecast upsells, subscriptions, and cross-sells.
It will help you understand the opportunities with the best returns and where you can cut investments.
You can even streamline your team goals. For example- your customer success team can focus on upselling revenue while the sales team can solely work toward new business.
3. Retention Strategies
You can analyze and engage your leads to improve retention. Proactive action can help you avoid churn of high-value clients.
If you see the recurring revenue declining from an existing customer, you can engage with them for retention.
Examples of ACV and ARR
Here are 3 sample customers, which we will use to explain the differences between both:
Customer A agrees to a $1000 / year, 1-year agreement and pays monthly.
Metrics calculated for Customer A Only:
ARR = $1000
ACV = $1000
Customer B agrees to a $750 / year, 2-year agreement and pays yearly.
Metrics calculated for Customer B Only:
ARR = $750
ACV = $750
Customer C agrees to a $500 / year, 3-year agreement and pays yearly.
Metrics calculated for Customer C Only:
ARR = $500
ACV = $500
Metrics calculated with all three customers, A, B & C combined:
ARR = $2,250
Year 1 = $750
Year 2 = $625
Year 3 = $500
Here are the calculations broken down:
ARR: $1000 + $750 + $500 = $2,250
Year 1: $1000 + $750 + $500 / 3 = $750
Year 2: $750 + $500 / 2 = $625
Year 3: $500 / 1 = $500
An Example Summary Sheet of ACV vs ARR
What is the Difference Between ARR and ACV?
While ACV gives you an overview of a client’s value over the contract term, you can use ARR for all the customers to calculate the total revenue stream.
ARR excludes the one-time charges, while ACV can include them depending on the company’s business.
ARR is a fool-proof metric to monitor and predict the business cash flow. The high-level management can use it to keep a bird-eye on the company’s performance.
ACV, on the other hand, tells you more about the quality of clients you have. It is primarily used by the sales & marketing team to improve the kind of business they bring in.
Best Practices to Boost ACV & ARR
1. Bundled Solutions
The simplest way to increase the ACV for clients is to encourage them to purchase additional features on top of their existing subscriptions. Upselling and cross-selling are not the easiest, though. It would be best if you pitch suitable solutions that combine with their current plan to provide a seamless experience.
2. Invest in Customer Service
Just a star product is not enough to attract customers. You need to level up with your services to maintain customer satisfaction. It will also increase the chances of product upselling and cross-selling in the coming times.
3. Revise Your Product Price
Increasing the price of your product will automatically boost your ACV and ARR, but there are things you must consider while doing so. Ensure the price hike is within reasonable limits and doesn’t throw you out of the competition altogether. Also, your product and customer service should justify the increase.
4. Localize Your Price
If you are using US dollars to offer your product, you might miss out on some opportunities. Not every country uses dollars as their business currency, so tailor your prices suitable to the local region.
It will cut the hassle of conversion and instantly connect with your audience.
Summing It Up
Running a SaaS business isn’t a cakewalk, but it can certainly be made easier with the right metrics.
Amidst the endless formula and calculations, it’s essential to use the ones that bring your whole organization on the same page. Straight away, plunging into overly complex metrics can lose their essence and value in a bigger team.
That’s why ACV and ARR are great tools to lay a strong foundation for SaaS business growth. Once you have mastered these basic but powerful metrics, you can upgrade your analysis with other data points like CAC.
Along with this, you can even track your product-led SaaS growth to align your tech with the sales and marketing team. For more information on how to optimize your lead conversions and grow your revenue, check out the ultimate guide to optimize B2B SaaS lead conversions and grow your revenue.
Frequently Asked Questions
1. What is ACV or Annual Contract Value?
Annual Contract Value, or ACV, is the average or normalized contract value of a client using your subscription for a year. It normalizes the total contract value to show the revenue you get from the client each year.
It’s calculated by subtracting the one-time costs from the total contract value and then dividing the difference by the contract term.
2. What is ARR or Annual Recurring Revenue?
Annual Recurring Revenue, or ARR, is the total of all recurring income you have received from your customers, excluding the one-time charges.
You can calculate this by multiplying the monthly recurring revenue from clients by 12. ARR can be calculated for a unique client or the whole client base, which tells about the company’s revenue generation.
3. What is Total Contract Value or TCV?
It’s the total revenue you get from a customer, including all one-time charges. It signifies the total cost a customer has to incur to subscribe to your services, whether it’s monthly or yearly. If your contract has any cancellation or onboarding fee, you can include that too in the calculation of the total contract value.
4. When should you use ARR and ACV?
ARR will give you insights into company revenue growth. At the same time, ACV will help you optimize business quality through sales and marketing. ACV helps you improve the quality of clients you bring for business as the team streamlines its efforts towards high-value clients. The difference between the two is that while ARR measures your recurring revenue at a single point in time, ACV normalizes that revenue across the contract term of the client.