How Is Annual Recurring Revenue Calculated

The term recurring revenue comes from the fact that this type of income is reoccuring, just like you would get paid monthly for employment or yearly for owning a business!

Recurring revenues are also referred to as subscription-based services or membership sites. This includes things such as Netflix, where you pay per month for streaming service or HootSuite, where you pay annually to use their social media management tool.

The key difference between one time purchases and recurring ones is how much money each product or service generates in profits for its seller/owner. For example, someone buying a book at an independent bookstore might spend $20 on it, but Amazon makes a ton off of that sale, so they have higher profit margins.

Businesses that rely heavily on recurring revenue typically offer products or services with high value, which people seem to keep coming back to because they believe it will make their life better or more productive.

Netflix has grown into a powerhouse by offering users premium content every year, and G Suite (Google’s productivity suite) has become very popular due to its free tier. Both of these things appeal to people who want to watch or use them, respectively, even if only once.

There are many other examples of companies that depend on recurring revenues including Spotify, Slack, and Shopify. All of these apps retain limited functionality for free, but then ask for payment for additional features and benefits.

Subscription models

Another way to classify software that receives credit for keeping a company afloat is through subscription services. Companies like Netflix, Prime Video, and Hulu are using their vast libraries of content to lure users in with premium features such as wider screen streaming or dedicated device apps.

These services cost either a monthly fee or an annual fee per user. The difference between the two is what kind of revenue they generate each year. If there’s no significant change in how much money these programs make annually, then it doesn’t get included when calculating IRR.

But if we take a look at some popular online platforms, you'll find that most don't include the upfront costs in their calculation. For example, Amazon's Prime membership comes with free 2-day shipping and access to its video library, both of which help solidify the service as profitable.

So why does Amazon exclude the price of the Prime Membership from their calculations? Because even though people have to pay an additional yearly fee to use certain features, those fees aren't enough to totally cover the initial investment. This means the rest of the year goes undeclared profit for the business!

This isn't necessarily a bad thing - especially not for Amazon! They're making plenty off of subscriptions, and growing their income every year. But it is important to know what kinds of benefits you're getting into before hand.

Automated renewals

Another way to quantify recurring revenue is through what’s known as automated renewal or subscription-based revenue. This occurs when someone signs up for your product or service, but you don’t directly receive payment until later.

The most common example of this are monthly subscriptions like Netflix or Amazon Prime. When you purchase these products, you typically have an active account immediately after, so they count as direct sales transactions.

However, if you didn’t use the product within the past month, then it gets cancelled and marked inactive. Technically speaking, that’s a cancellation transaction, which doesn’t include any sale fees in its calculation.

With the recurring revenue number being artificially low due to this, some companies will add in how much money was spent per year on marketing materials such as brochures and advertisements to make the total yearly conversion amount seem higher.

This isn’t necessarily wrong, but it does play into why some people may question recurrece numbers because they feel those who report them aren’t telling the full story.

Recurring billing

Another way to define recurring revenue is “ongoing business relationships” or what some call “repeat customers.” This is when you earn money from return purchases of a product or service. For example, if you are reading this article online then I likely receive an income stream from your continued attention.

I understand that my content is valuable to you so I am compensated for it through these advertisements, sponsors, and/or affiliate links in this article. Most of these companies will agree to pay us for our efforts to promote their products.

This is why I include affiliate links here for Gutter Guard Systems because I have been paid to recommend them. If you want to learn more about gutter guards check out My Recent Additions!

Products with recurring revenues are much easier to achieve success as a entrepreneur than those with up-and-down incomes. Because even though there may be a lull between purchaseings, you still get paid for the relationship you created with your audience.

Recurring revenues are great because you do not need to worry about getting the next big paycheck like they do with steady jobs. With recurrent revenues, you can live comfortably every month!

What is The Difference Between Ongoing Business Relationships And Steady Income?

Ongoing business relationships are definitely better than no income at all, but they are very different from steady income. They help supply part of your income, but things look different depending on how you perceive income.

Fee-based models

In the fee-based model, you offer services or products for a monthly or yearly subscription. Your fees are usually paid at the time of purchase, with no initial free trial period.

Monthly subscriptions can be done through per month service plans or as an annual membership which is often less expensive due to the lower average consumption requirement per user.

With a monthly subscription, your users pay one price each month until they cancel their account. With an annual memberailty plan, your users will pay an up front cost that gives them access to your resources for a whole year! This is typically more affordable than a monthly service plan.

Annual memberships also give your business additional revenue since it does not need to promote the product to new customers every month. Since there is no longer a beginning and ending to the relationship, this creates an easier marketing task.

Cost per acquisition

So how is recurring revenue calculated? It’s the total amount of money you spend to acquire a customer divided by the number of months since their last purchase!

The math doesn’t quite work out perfectly, but this calculation gives us a good estimate of how much monthly recurring income we should be expecting from our customers.

If you are reading this article right now, that means we already have some recurring revenues!

We received an email notification every time you opened this page in your browser. You paid for our service each month! This is what allowed us to keep investing in the website infrastructure and research to find helpful tips and tricks for G Suite apps and services.

Now that we covered why it’s important to understand IRR, let's dive into some examples.