ACV vs. ARR: Definition, calculation and importance

For any SaaS company, tracking business growth and financial health is essential. Tracking positive growth trends gives you a perspective of your business health and helps you make strategic business decisions.

 ACV and ARR are essential metrics that can help you quantify and manage your Saas business growth. It is vital to unpack ACV vs. ARR because these terms are pretty similar but differ significantly.

This article will give you a good understanding of both terms, how they work, and when to use them to track business performance.

ACV (annual contract value)

ACV simply means annual contract value. 

Annual contract value, ACV is a metric that measures the average value a company generates from a customer's contract within a year. As such, ACV is an average annualized revenue per customer contract.

There is no standard way of calculating ACV. However, its calculation typically involves just recurring revenue; it excludes one-time fees like onboarding fees and other administrative fees. It is advisable to exclude non-recurring incomes because they do not contribute to your gross income in the long run. They only help you cover your operating expenses.

ACV is often used by Saas companies selling multi-year or yearly subscriptions. However, you can also use it to quantify the value of monthly subscription contracts and differently priced plan accounts.   

Although tracking ACV as a standalone metric may offer little ins when ACV is compared to other sales and revenue metrics such as CAC and customer acquisition cost, you can gain insight into your business performance and set realistic revenue goals. Comparing ACV to CAC can give you an insight into how much you spend to acquire a customer and your ROI. 

Importance of calculating ACV 

The following are some benefits of calculating ACV :

Identify and prioritize high-value accounts

ACV measures measure annualized contract values. It gives an insight into how much income you make from each client annually. This can help you compare the value of recurring revenue accounts, as well as each customer and provide insight into how to serve the individual client better.

High-value customers deserve more attention, and customer success strategies to retain and possibly upsell them. Such clients may be targeted with discounts and other juicy offers to convince them to renew their contracts as it's approaching an end. 

Track the performance of your sales representatives 

As you can recognize each customer's worth and ascertain the sales reps responsible for closing such deals, you will also be able to measure how much each sales rep makes for your business annually.

With such insight and other performance metrics, you can measure the ROI of your recruitment and human resources efforts. High-performing salespersons can be rewarded to encourage them, and more training can be targeted towards underperforming ones. 

Measure profitability and set realistic business goals

When you compare your customer acquisition cost to your ACV and lifetime value, you can ascertain how long it takes to profit from each customer account and your overall ROI.

Aside from determining individual account ROI, ACV is also beneficial for business goal setting and revenue forecasting. 

You can calculate your total customer acquisition cost, the amount you spent on acquiring all your customers, and how many customers you need to reach annually to recover your customer acquisition cost plus handsome profit. Customer conversion rate and ACV can also be considered to forecast your business revenue for a specific period effectively.

How to calculate ACV 

There are different approaches to ACV sales calculating because of varied contract values and duration. Some customers may sign up for multiple years or less than one year.

Generally, ACV formula = TCV, Total contract value/contract duration in years.

How to calculate ACV for long-term contract 

For instance, a client signs a five-year contract for $10,000. The ACV will be 10,000/5=$ 2000. 

How to calculate ACV for a short-term contract 

A client signs a six months contract for $2000. Even though the contract is less than one year, ACV is an annualized contract value; it is calculated annually and not based on contract length. As such, the ACV will be $2000/1 year. The annual contract value will be $2000. 

How to calculate ACV for multiple contracts

Here, we want to calculate the total ACV for three clients. Customer A signs a two years contract for $3000. Customer B signs a three years contract for $6000, and customer C signs a six months contract for $1200

ACV for customer A = 3000/2= $1500

ACV for customer B= 6000/3= $2000

ACV for customer C = 1500/1= $1200

Total ACV= 1500+2000+1200= $4700

After getting your total ACV, you can calculate the average annual contract value across all the contracts. 

Average ACV = Total ACV/ number of contracts 

$4700/3= $1567.

ARR

ARR, which means annual recurring revenue, is the total yearly revenue a Saas business can expect to generate from all its existing customers. It is the summation of predictable and regular income you wish for annually from all your subscription accounts. ARR allows you to quantify your active customer subscriptions' total recurring annual value. 

ARR is an important Saas metric that helps you measure your year-over-year recurring revenue and business performance. ARR calculation considers some subsidiary metrics that may cause revenue fluctuations in the long run, such as ; 

New Revenue includes revenue from new customers and customers who renewed their subscriptions. 

Upgrade revenue (expansion revenue) is generated when customers upgrade from a low-value subscription to a higher-value plan. It may also have an additional add - a recurring customer account. Such additions will affect the value of a customer's contract and your total ARR.

Downgrade revenue includes Revenue reduction when customers move from high-value subscription plans to lower-value plans will also reduce their customer value and overall ARR. 

Customer Churn: Revenue lost due to customers that canceled their plan needs to be excluded from your calculation to get an accurate ARR. 

ARR is an industry-standard metric. Its calculation excludes one-time fees such as onboarding fees, add-ons that are not recurring, and other administrative fees that are not recurring. 

Importance of calculating ARR

Track business financial health

ARR is a momentum metric. It shows how your annual revenue is compounding or fluctuating. 

As such, you are calculating ARR helps you track your revenue growth and general financial performance. It shows what you make annually, where the revenue comes from, and why it's increasing or decreasing yearly.

Strategic decision making 

Insights gained from your ARR can shape your business strategy and ways of improving your bottom line. For instance, If you notice a decrease in your ARR due to account downgrades and canceled plans, you may want to investigate possible reasons for customer dissatisfaction. This means your customer success and retention strategies need improvement. 

Getting customer feedback can also give you an insight into what customers want and ways to upsell or cross-sell them to increase your revenue.

Revenue forecast 

ARR is a baseline metric that can help you make safe future projections. You can easily incorporate it into more complex calculations. ARR can give insight into the value of your renewals and churn rate. Cross-referencing your ARR against churn rate, customer acquisition goal, and potential adjustment in your package pricing, you will be able to project your future performance and make a reasonable financial plan.

Evaluate the success of your subscription-based business model 

ARR is only concerned with recurring fees and doesn't include other static incomes. By tracking the value of your annual income from your subscription, you will be able to decide whether the subscription business model is generating more profit or switching to a better model. 

How to calculate ARR

There are several ways to calculate how much recurring revenue you generate annually.

Method 1 (MRR ×12)

If pricing plans rely more on Monthly Recurring Revenue (MRR), Simply calculate your ARR by multiplying your monthly recurring revenue (MRR) by 12. 

ARR = MRR×12

To do this, sum up the value of all your ongoing customer contracts. Ensure you exclude one-off fees like an account set-up and administrative costs from your calculation. Consider revenue increase due to new account sign-ups subscription upgrades and add one. Also, make adjustments for account downgrades and canceled subscription plans. 

Method 2 Adjust your revenue fluctuations. 

In a more comprehensive calculation, you can calculate your ARR by adding the total value of your subscription contract to the value of your account upgrades and add - ons to your and then subtracting the value of your account downgrades and cancellations. Here, 

ARR = Overall Subscription Cost Per Year + Recurring Revenue Upgrades and Add-ons Revenue Lost from Downgrades and Cancellations.

Is ACV the same as ARR?

Annual Contract Value, ACV, and Annual Recurring Revenue ARR are both annual revenue valuation metrics utilized by Saas business owners. Both are similar and can be easily mistaken for one another. However, there is a sharp difference between the two. 

The significant difference is that ACV measures the value of recurring revenue expected from individual accounts annually. In contrast, ARR measures the total dollar value of all recurring revenue anticipated or generated from all customer accounts annually. ACV deals with a single customer account, while ARR deals with all customer accounts.

All your User accounts have individual ACVs regardless of their pricing plans. You can get your Annual Recurring Revenue by adding the ACV of all existing customer accounts, provided that you excluded one-off fees when calculating your ACVs. 

For instance, if you have 50 customers with $200 ACVs each, you can get your ARR by multiplying $200 by 5. 

This brings us to another difference between the two metrics. Unlike ACV, ARR is an industry-standard metric. Its calculation excluded one-time fees. ACV is not an industry-standard metric. You can include one-time fees in your calculation even though you shouldn't.

Lastly, ARR is not just a standard metric; it is a standalone metric that can measure revenue growth. ACV, on the other hand, is not a complete measure of revenue growth; it has to be compared to other revenue metrics, such as Customer Acquisition Cost(CAC), Customer Lifetime Value ( (CLV), and Annual Revenue Value( ARR) to get a clear picture of your revenue growth and financial health. 

Examples of ACV and ARR 

You need a practical example of how ACV and ARR work to understand their relationship and differences. 

A company's pricing plan is as follows; 

Basic: $500 annually 

Advance: $1000 annually 

Enterprise: $2000 annually 

Four customers sign up for a five-year basic account at $2500 each. One customer signed up for an advanced contract at $3000 for three years, and the two signed up for an enterprise account for two years at $2000 each. All contract values exclude one-off fees. 

Basic account ACV= $500 ×4

Advance account ACV= $1000 ×1

Enterprise Account ACV = $ 2000 ×2

Total ACV for the first year = 2000 +1000+$4000= $7000.

The company's ARR for the first year is also = $7000 

Two essential customers upgraded to advanced accounts. The sole advanced account customer downgraded his account to basic. Let's assume after the first year, the company gained three new customers who signed up for an enterprise account for two years each. One of the old enterprise account customers canceled her subscription.

Company's ACV for the second year ; 

Basic account ACV = $500 ×3 = $1500

Advance account ACV = $1000×2=2000

Enterprise account ACV = $2000×4= $8000

Total ACV= 11,500

The company's second-year ARR

3 new enterprise customers = 2000×3= $6000

Two upgrades from basic to advance = 500×2= $100

One downgrade from advanced to basic= $500

1 canceled enterprise account =$ 2000

ARR = Initial ARR + revenue from new customers + account upgrade - account downgrade - lost customer 

ARR=( $7000+$6000+$1000)-$500-$2000)= $11,500

When to use ACV and ARR 

ARR and ACV may be similar, but each metric affects your business differently. As such, their uses differ. 

ARR is a significant metric that can show progression or regression in company performance compared year over year. Comparing your ARR to your competitors can also show your progress compared to your pairs. ARR is a valuable metric for company board directors and managers( revenue leaders) because it plays a significant role in decision-making. Investors also consider a company's ARR a vital investment decision metric. A subscription as a service company with low ARR is no doubt not profitable. 

ACV, the annual contract value, is only one of the essential metrics when tracking your company's performance and growth. A low or high ACV may not significantly affect a company's revenue. A company with a low ACV spread across millions of customers may be more profitable than a company with a high ACV spread across a few thousand customers. There is no standard ACV; it depends on your pricing strategy. A company like Netflix has been able to record success despite its low ACV due to its large customer base. Its low ACV is a marketing strategy that attracts a lot of customers. 

As such, ACV should be used as something other than a standalone metric to measure your company's growth. ACV can be more useful when you track sales growth and performance of your sales and marketing team- their ability to attract new customers, retain, upsell or cross-sell existing ones. It will give you insight into the effectiveness of your sales and marketing efforts. You will know what is working, marketing, and sales strategy that needs improvement.

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