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Running your business without knowing how much revenue you will receive in a given period is not a good idea. Revenues come in cycles, so it makes sense to expect this.
Running out of money is also a bad idea, which can be even more difficult when you have no clue how much money you need to stay afloat!
Fortunately, there are ways to calculate annual recurring revenue (ARR) using different metrics and formulas. This article will go into detail about some ARR calculation strategies that can help you get a solid understanding of this important metric.
At the end, I will provide my opinion on the best way to use ARR for business purposes. You may want to refer back to these points as needed. So let’s dive in!
Calculating Annual Recurring Revenue-Part 1: The Basics
The basics of calculating annual recurring revenue include looking at the duration or length of engagement of a service vs individual users, and then adding up all of the recurrent costs for each user.
These two components are then added together to create an overall number representing the cost of running the service per year. Some businesses only focus on one component of the equation or the other, but both play an integral role in determining if a model is sustainable long term.
There are three main reasons why most business models do not contain ARRs.
Monthly recurring revenues are calculated in much the same way as one-time or repeat sales, except that it is done at a monthly level instead of an individual transaction level.
Monthly recurring revenues include things such as subscription services (for example, Netflix or Amazon Prime) or software subscriptions (for example, Microsoft Office 365 or Photoshop). Many companies offer a yearly membership to their website or service, which some people may not use but still want access to the facilities. This does not qualify as true recurring revenue, however; it is only monies received back once during the year!
Many businesses will promote a subscription service or plan through advertisements or via direct marketing. By tracking these purchases online or by talking to other members of the business, you can determine how many subscribers there are and how much money they bring in per month. A simple way to calculate annual recurring revenue is to divide the total amount spent on each service for the given time period by the number of months in this time frame.
This would be equivalent to calculating how much was spent on the company’s product over one full year rather than one month.
So how do you calculate annual recurring revenue? Simply multiply your initial investment times your monthly recurring revenue!
The important thing to note about this calculation is that it does not include any additional costs or fees to maintain or promote the service. These are part of the cost of producing the product – they are not included in the monthly recurring revenue number.
For example, if you spent $1,000 to develop an app that has a monthly recurring revenue of $500 per month, then its annual recurring revenue would be $50,000. This is because you invested $1,000 so half of that is $500 which is multiplied by 12 for the year.
You can also use the opposite approach to determine what kind of business has little to no potential annual profit. By dividing the monthly revenue by the same factor, you get an estimate of how long it will take to break even. More expensive services typically have longer time frames than less expensive ones.
The next step in calculating your ARR is to calculate how much money you expect to get back from your partners, vendors, or customers every year. This is referred to as your average time frame or engagement level with you.
Most entrepreneurs use an online tool to help them track this information. Many of these tools automatically update as new data becomes available, which saves you the hassle of doing it manually!
Some examples of ways to determine your engagement levels are by looking at past purchases, current subscriptions, or monthly or yearly fees.
You can also ask yourself or your colleagues what their expectations are for investing in you or your product/service. A good way to do this is via surveys or questions that have “hard” numbers like 1-5 scale or yes/no responses.
Once you have all of this info, you can add up all of the answers to come up with an average time frame.
The break-even point is important to determine when starting an organization is profitable or not. This is the number needed to run your business for one year before you make a profit.
The break even point is usually calculated by taking the monthly revenue of the company and dividing it by the monthly expenses, then multiplying that ratio by 12 to get the total amount spent per month.
This includes things such as rent, utilities, marketing, website costs, etc. Then, we multiply this value by twelve so we can come up with the break even point.
At this point, if the product or service cost more than the income it generates in a year, then it’s not sustainable and should be dropped. It’s better to start off low and grow from there than invest lots of money into something that doesn’t work.
So how do you know if your startup is financially stable? Simply look at your breaks down - what does every department earn? If everything is well within reach, then your company has enough resources to stay afloat for a while.
By calculating the break even point, we are able to identify whether or not our company has enough revenues to keep running for one full year.
A crucial part of determining if an activity is worth continuing or not is calculating the return on investment (ROI). This is typically done by dividing annual revenue by monthly expenses, then comparing that ratio against the benchmark number 2.5.
If the ratio is greater than 2.5, then the activity is considered profitable and therefore worthy of keeping going. If it’s less than this, then you should consider dropping it unless you are willing to put in extra effort to keep it afloat.
We spoke about how to calculate monthly budget costs here, so check out those tips again for more information!
Annual recurring revenues can be calculated using two different methods: direct calculation and extrapolation. Directly calculating ARR means taking the yearly sum of income and adding onto it all the running fees and other overhead costs associated with the activity.
Extrapolating ARRs means estimating what your income will be next year based off of past trends. Many entrepreneurs use pre-tax profit as their base, which is the total amount left over after accounting for taxes. They then add onto this the cost of employee benefits like health insurance, and list all the additional fees related to the business suchas domain names and hosting.
This article will focus on directly calculating ARRs.
The second key piece of calculating ARR is negotiating with the other party about what you want your ARB to be. This can get tricky because companies will use different definitions for ARB, so it’s important to know what their cutoff points are before agreeing to anything.
Most major corporations define ARB as monthly revenue less than $100,000 per month. Some go up to $150,000 per month, but those numbers are very high. A better number to use is the one we mentioned earlier: monthly revenue less than $20,000 per month.
This definition is much more reasonable because it assumes that an employee leaving the company would take at least two months to find another position, which seems fair. If this doesn’t apply to you then use the higher amount!
Remember though, if a member of the team consistently pulls out then it could affect the overall calculation. Take into account how likely they are to leave and whether or not giving them their wanted money would push them away.
After you have gathered all of your equipment and supplies, it is time to open an easy-access business banking account. This will allow you to easily deposit money coming in from sales or advertising, as well as take out money for costs such as shipping and marketing.
It is also important to have a business credit card with no annual fees or significant monthly dues. You want to make sure that you can spend without worry when you need to!
You may also wish to consider investing in some form of online billing software to help track your income and expenses. There are many free ones available as well as paid versions.
Annual recurring revenue (ARR) comes down to one key thing: consistent income. If you do not have steady income, then it is impossible to keep up momentum and growth of your business.
Most entrepreneurs find that having an extra budget day each month to focus on growing their business is what works best for them.
It’s very important to have a formalized way of keeping track of your expenses, but there is an additional element you should be aware of — how to calculate annual recurring revenue (ARR).
Most startups struggle with this because they don’t know what ARR actually means!
Many entrepreneurs think that just adding up all of their monthly income and dividing it by the number of months in a given time period gives them their “monthly net profit.” They then apply normal percent formulas to determine whether or not they are making enough money per month.
This can lead to some significant overestimates of profitability due to two main reasons. First, many entrepreneurs fail to take into account any potential losses that occur during times when they aren’t getting paid. Second, many fail to include any possible savings in costs from having less overhead such as rent or employment.
These factors can easily add up and negate any perceived profits at least for a short amount of time. This risk is especially high for startup owners who may need to find new jobs soon after investing heavily in marketing strategies.
Fortunately, there are ways to fix this. The easiest solution is to use the same method most major corporations use to measure profitability – average daily revenue (ADR). ADRs are simply calculated by taking the total cost of goods sold plus services divided by the number of days in the calculation window.
