As you are searching for ACV and ARR, you may already know or have an idea that these two are revenue-related metrics. Many SaaS companies are leveraging these metrics to improve their business models and overall performance. However, there always seems to be confusion between ACV (Actual Contract Value) and ARR (Average Recurring Revenue). Any SaaS business owner needs to understand that calculating these two metrics is essential before any financial reporting period ends. Keep reading to clarify the confusion between ACV and ARR, their benefits, and how you can calculate them.
ACV (Annual Contract Value)
ACV, or Annual Contract Value, is one of the most crucial SaaS metrics that can help you gauge the average value of a customer’s contract or subscription over a year. ACV comes in handy whenever you need to make any strategic, financial, or marketing decisions. Utilizing the Annual Contract Value metric, you can determine each customer’s revenue potential and effectively retain high-valued customers through effective segmentation. SaaS product owners can find several business growth and strategy improvement opportunities by calculating the Annual Contract Value (ACV).
How to Calculate ACV?
As there is no uniform formula for calculating Annual Contract Value, many consider it one of the most misunderstood SaaS metrics. However, the fact is calculating the Annual Contract Value in any SaaS business is simple. Companies use ACV to compare their business performance and growth against competitors. But while doing so, you must ensure to use the same ACV calculation method that your competitor use, or else, the results may not be helpful.
Calculating ACV involves summing up the total contract value for all customers minus one-time subscription fees or charges and dividing it by the total number of years in the contract. SaaS owners often require calculating ACV for customers that have subscribed to the product or services for short-term and long-term contracts. Let us understand how you can calculate ACV in SaaS business:
For Long-Term Contracts:
Suppose you need to calculate ACV for customers that have subscribed to your SaaS product for 5 years with $15000 TCV. Then the ACV will be $3000.
| $15000 TCV/5 Years = $3000 ACV |
For Short-Term Contracts:
When it comes to calculating ACV for short-term contracts, you need to annualize the total revenue from the subscription contract. Assuming the contract is set for auto-renewal, the ACV of a six-month contract for $6000 TCV is $12000.
| $6000 TCV/0.5 Years = $12000 ACV |
Benefits of ACV in SaaS
ACV (Annual Contract Value) help SaaS businesses optimize their sales efforts and strategies for long-term success. The benefits of Annual Contract Value are what makes it an essential SaaS metric, and they are as follows:
Identify Customer Value: If you need to identify high-value customers, the best way is to calculate Actual Contract Value. Yes, ACV allows you to find high-paying customers and target them for retention and contract extensions.
Effective Business Strategies: First of all, you should know that a low Actual Contract Value doesn’t mean low business value and profit. For example, Spotify has a low ACV but gains high profit from its large customer base. Tracking the ACV of your SaaS business helps you understand how many more customers you need to achieve the defined revenue goals. It will also help in planning effective business strategies and making informed decisions.
Improvise Sales and Marketing Efforts: ACV helps you target the right customers so you can prioritize sales and marketing accordingly. It also allows you to offer tailored pricing plans and offers to meet different customer needs and maximize revenue potential.
ARR (Annual Recurring Revenue)
Annual Recurring Revenue is the best SaaS metric for SaaS owners that need to predict the revenue their product or business can generate from its customers per year. ARR allows businesses to measure and forecast business and financial growth year-over-year, making it the finest among SaaS metrics. It will be feasible for you to determine financial performance and make informed decisions related to budgeting, resource allocation, and growth strategies. With the help of ARR, businesses can identify opportunities to optimize revenue generation.
How to Calculate ARR?
Annual Recurring Revenue is basically the Monthly Recurring Revenue (MRR) minus Monthly Recurring Revenue (MRR) Churn multiplied by 12 to find ARR over a year. Most SaaS businesses consider ARR a good metric for evaluating the business’s financial health. There is no need to divide the value when we are calculating ARR. Let’s understand it better with the below example:
Users A, B, and C are paying an annual subscription fee of $2500, $2000, and $1500. However, User A doesn’t want to renew the subscription, User B wants to renew the contract for another year, and User C wants to carry on the subscription for 3 years. So, the ARR calculation will be as follows:
Year 1: ($2500 + $2000 + $1500) = $6000 ARR
Year 2: ($2000 + $1500) = $3500 ARR
Year 3: ($1500) = $1500 ARR
Benefits of ARR in SaaS
In the Software-as-a-Service industry, Annual Recurring Revenue (ARR) happens to be a critical metric that offers several benefits for SaaS businesses. They are as follows:
Predictable Revenue: With the help of Annual Recurring Revenue, you can easily determine the recurring revenue you expect over a specific period. Hence, it helps in financial planning and resource allocation.
Customer Retention: ARR helps SaaS businesses evaluate the customer retention rate while monitoring the loss of customers. Businesses can proactively improve customer satisfaction by closely tracking customer churn rate and retention.
Valuation and Investor Confidence: As you know, Annual Recurring Revenue (ARR) plays a significant role in assessing the company’s value. ARR acts as an indicator to measure business performance for potential investors.
Conclusion
In conclusion, SaaS companies that want to accurately measure their financial performance and growth can leverage ACV and ARR metrics. As both these metrics have different use cases, you should choose the right SaaS metrics as per your business objectives and requirements. By partnering with a SaaS development company, you can create robust and efficient tracking software solutions that help in measuring and analyzing ACV and ARR effectively. ACV can help you assess the immediate revenue impact by measuring the actual value of the contracts. In contrast, ARR can assist you in revenue prediction and facilitate long-term planning and business growth strategies. Hence, utilizing both metrics allows businesses to make informed decisions, improve customer retention, and drive business success.
Author Bio:
Chandresh Patel is a CEO, Agile coach, and founder of Bacancy Technology. His truly entrepreneurial spirit, skillful expertise, and extensive knowledge in Agile software development services have helped the organization to achieve new heights of success. Chandresh is fronting the organization into global markets in a systematic, innovative, and collaborative way to fulfill custom software development needs and provide optimum quality.
