Every SaaS company at the enterprise level, and those whose business model relies heavily on yearly contracts and subscriptions are familiar with the terms “annual contract value” (ACV) and “annual recurring revenue” (ARR).
So, what does it really mean for a sales or marketing professional, or for the Finance teams in an organization. With global SaaS revenue pitched to reach $140.6 billion in 2022, according to Gartner’s forecast, and considering the many KPIs SaaS companies track and measure to analyze their growth, it’s important to understand ACV and ARR as concepts.
Here, we explain the ACV and ARR metrics in detail, and also why they are essential and how to calculate them. It’s also important to know how ACV is different from ARR and how the two are put to use by SaaS marketers.
What does Annual Contract Value mean?
ACV (Annual Contract Value) is a key indicator that reveals the average and normalized value of an ongoing customer contract over the course of one year.
Your customers’ accounts can be valued using ACV, whether they include:
- Recurring monthly payments
- Plans with varying costs
- Multi-year contracts
Calculations of ACV sales are usually based on the recurring income generated by a single customer or account and do not generally include initial or one-time configuration, training or administrative costs.
What does ARR mean?
Annual Recurring Revenue is referred to as ARR. You can use the Annual Recurring Revenue to see how much yearly recurring revenue you’re making from all of your subscriptions. Because of this, you can use ARR for the following:
- Calculate your annual recurring revenue in terms of total dollars.
- A means of obtaining a comprehensive view of your cash flow as well as ways to enhance your cash flow, it does not take into consideration one-time fees and levies. In other words, you can see how much money you’re making at any given moment.
Aside from that, Annual Recurring Revenue can also be used to track the following momentum:
- New customers’ annual recurring revenue
- Recurring annual revenue from existing clients
- An increase in Annual Recurring Revenue (ARR) as a result of new features and upgrades
- Annual Recurring Revenue (ARR) reductions or contractions due to downgrades in value
- Churn in the revenue stream, which is a loss of revenue on an annual basis.
For each of these components, the Annual Recurring Revenue is calculated and reported using either an absolute figure, a relative value, or a change over time.
(Detailed Guide: What is ARR – Annual Recurring Revenue? )
What’s the Difference Between ACV and ARR?
Both of these indicators are based on annualized contract values, which typically leads to confusion about both terms. There are however a few important distinctions, which we will discuss in the following table:
|Annual Contract Value (ACV)||Annual Recurring Revenue (ARR)|
|The revenue generated by a single, subscription-based contract can be calculated using the annual contract value metric.||All subscription-based contracts of the company are measured with the Annual Recurring Revenue statistic.|
|Using this metric, the average annual contract value is calculated as an average dollar figure nominalized over a year.||Recurring revenue is measured by this metric as the total yearly dollar amount generated.|
|There are a variety of ACV sales formulas to choose from, depending on how your firm plans to use the data!||All SaaS businesses use the same ARR formula.|
|When used alone, ACV has a restricted range of applications because it is not an exact number. For this reason, it is most effective when used in conjunction with other measurements.||Because ARR is a specific number, it may be used to track sales growth and make smarter business decisions.|
|Depending on the needs of the business, ACV may comprise one-time or initial contract fees.||In the case of ARR, the initial or one-time contract fees are never included.|
|The formula for ACV = ƒ Sum(Value of all Customer Contracts for a year) / Count(# of Customers under Contract)||The formula for ARR = ƒ Sum(Recurring Revenue irrespective of billing interval expressed as an annual value)|
How do you work out ACV?
For a single account, the usual formula for determining the Annual Contract Value is:
- ACV= Total Contract Value/ Number of Years
For example, if a client X obtains a 5-year-long yearly subscription contract with the overall investment being $5000, therefore its Annual Contract Value would be:
- ACV= 5000/5 = $1000
However, if, for instance, customer Y decides to commit to a two-year, $300-a-month subscription? Customer Y’s contract will be normalized over a year using the ACV formula:
- Annual subscription rate= $300 x 12 months = $3600
- Total contract value = $3600 x 2 years = $7200
- Therefore, ACV = $7200/2 = $3600
As a result, SaaS companies can use the annual contract value as a sales indicator to compare different types of recurring revenue accounts.
How do you calculate the ARR?
The standard and accurate method for calculating ARR is quick and simple. This is done by removing the prior year’s annual revenue from your non-recurring income. Thus,
- ARR = Total Annual Revenue – Non-Recurring Revenue
However, this formula has limitations because it does not account for changes in customer subscriptions over time. This leads us to the standard formula for determining ARR, which is as follows:
ARR= ARR at the beginning of the Year + ARR gained from new customers + ARR gained from subscription upgrades – ARR lost to subscription downgrades – ARR lost to customer churn
Maintaining a positive growth trend is just as important for the success of your business as SaaS companies are becoming more popular and widely utilized. It’s possible to keep track of your business finances by using metrics like Annual Recurring Revenue (ARR) and Annual Contract Value (ACV).
Thus, by monitoring these ACV vs ARR metrics, you can make sure that your sales, profits, and customer satisfaction are always at their highest possible levels.