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The term recurring revenue was coined in a Harvard Business School paper published in 2004 called “The Financial Size of Your Company Based On Two Indicators”.1 In this article, the authors defined recurring revenue as follows:
Recurring revenue is revenue that comes back to you seasonally or yearly. This can be monthly subscriptions, quarterly discounts, annual memberships, or any other type of repeat business.
They also noted that most companies consider themselves to have some level of recurring revenue, but what exact definition of recurring revenue they use varies widely.
Some define it as anything beyond month-to-month fluctuations, while others include only direct repeats such as subscription services or yearly contracts. Some even go so far as to not count sales under half a year as part of their calculation!
With all these different definitions, no clear standard for defining how much recurring revenue a company has exists. But we can take a good look at Amazon to get an idea of how to calculate it.
We will assume that Amazon is starting to think about expanding into another product line that generates around $2 million per year. Let’s say its new product line is for skateboards. (Yes, really.)
Their current products already make enough money each year, so let's just add one more thing to sell them and then see where things go from there.
Now that you have determined how much revenue you expect to get in a given period, your next step is to determine how many months of this period are considered part of the annual calculation. For most businesses, it’s twelve months! So instead of having one month as part of the yearly calculation, one month has been multiplied by twelve to include a full year of income.
This changes the numbers slightly, but not dramatically so it isn’t something that needs too much attention unless necessary. However, if you are very careful with your calculations, it can save you some significant amounts of money in the underestimation or overestimation of IRR.
Another important thing to note about calculating IRRs is that there are two different ways to calculate them. The first is using the direct method and the second is using the indirect method. This article will go into more detail about each one.
The multiplier of 1.2 comes from looking at it in two different ways. First, you can look at it as how much revenue you’ll earn per year. This is referred to as annual gross profit or GAIN (revenue minus cost of goods sold).
By taking this approach, we see that 1.2 represents about 20% more gain for your business each year!
The second way to calculate this number is to think about it as how many years you will make an average of with this product. By multiplying by 1.2, you get one extra year of growth over what you have now!
This seems like a small difference, but when you are talking about growing a company, every little bit helps. These products keep coming back because they offer enough value to outweigh their price.
Now that you have determined how much revenue is being generated per month, you can multiply this number by 1.25 to determine how much annual recurring revenue is being generated.
So for example, if your monthly revenue was $1,000 then multiplied by 1.25 it would calculate as an annual recurring revenue of $12,750!
This makes more sense than just looking at yearly revenues because along with the monthly income there are also costs involved in running the business each year. This includes things such as marketing expenses, employee payroll, website hosting fees and more. All these cost money and need to be considered when calculating whether or not the business is profitable.
There are many ways to evaluate the profitability of your business, but one of the most important factors is determining its break-even point. The break-even point is the point where the business has enough revenue to cover its operating costs. When calculated on per month basis, this changes slightly and becomes the point where the business will make enough money per month to pay off its monthly operating costs.
The second way to calculate ARR is via the calculation of monthly recurring revenues (MRV) and yearly MRVs. Monthly recurring revenues are calculated by taking the sum of all the monthly subscription fees you have for your products or services, and then dividing that total by the number of months in the given time period.
Yearly recurring revenues work similarly, except we instead divide our monthly totals by the number of days in a year. For example, if you were to purchase a software package every month for one year, this would be considered an annual plan with 1 year’s worth of access.
Because we are using ratios here, it becomes easy to compare how much money you make per day, per week, per month, and so on! When calculating MRVs, remember to include the initial investment as part of the numerator and not the denominator. This helps account for things like memberships that do not renew each year but come back around at another point during the same year.
Note: Depending on what type of business you run, it may be more appropriate to classify certain subscriptions as non-recurring rather than recurring. This is due to the fact that they occur only once every X amount of time. Examples might be a membership website or fitness training program that costs $100 for a year but individuals can only use it through the winter season because there is no longer a summer session.
The number in the parenthesis is how many months it will take to fully re-invest your revenue into the company. This is called the ‘calendar period’. For example, if you invest $1,000 per month for one year in advertising, then your annual recurring revenue (ARR) would be $12, 000.
This calculation does not include the initial investment of money, only the cost of maintaining the service or product you already have. This can easily be done when you start your business because it is usually spent on fees for licenses, website hosting, marketing materials and general running costs such as electricity and water.
By adding these additional expenses onto the monthly investing amount, you get an overall average of what ARR is.
The easy way to calculate annual recurring revenue (ARR) is to multiply the number in the numerator of the formula by 1.2.
The hard way to do this is look at how much money you made during the last twelve months, then divide that amount by one year to get your yearly average. Then take the square root of that value to find the ARR.
This can be tricky because not all companies report what their monthly or weekly earnings are. Some only release their yearly numbers instead!
We found an alternative method using averages for this article. It may also be better than just taking the square root of the yearly income since it removes any outliers that might distort the result.
Now that you have determined your ARR per month, you need to multiply this number by 1.25 to get your annualized ARR. This is because there are one extra month in each year compared to monthly revenue.
So for example, if your MRV was $1,000 per month, then multiplied by 1.25 it would total $1,250 per annum or $125k over 12 months.
The term discount refers to how much you are giving someone for buying or using your product or service. A promotional offer is when you give something free in exchange for them promoting your product or service.
Discounts and promos can easily skew the numbers of what it takes to make a profit, so they must be excluded when calculating ARR. This is because these products/services are not paid for directly through revenue, but via concessions (discounted prices) or promotions (free items).
By including these costs in the calculation, you may be overestimating the true profitability of your business. It could also distort the picture of whether or not your business is making a profit or loss.
To avoid this, we will be excluding all direct discounts and promo offers from our calculations. These include price drops that occur every week or month, as well as free samples or introductory pricing.
