ARR vs ACV Sales vs TCV. Before we begin covering the differences, let’s discuss each of these terms individually.
First, what does ARR stand for?
Annual Run Rate is a measurement of your company’s revenue. Annual Recurring Revenue (ARR) measures the average annual value for each customer over the course of their subscription.
Revenue is a key metric for measuring your business’s success, but it comes in two forms: revenue and profit. Revenue refers to the total amount of money that has been made by selling goods or services, whereas profit is how much you make after all expenses have been paid.
Even if you find the same numbers, different financial terms will have a variety of definitions and interpretations. Click To Tweet
This can be frustrating because it becomes hard to compare apples-to-apples metrics such as ACV (annual contract value) and ARR (average revenue per user). The problem is that every business unit may use its own calculation for these important figures.
Annual Run Rate
The term “Annual Run Rate” is used to describe a method of extrapolating earnings from a shorter time frame. The Annual Run Rate usually represents the size of the business in terms of annual revenues.
Let’s say your company made $100,000 in January; you could predict that it would be a total of $1.2 million for the year by multiplying this amount with 12 months.
Run rates are often used to measure a company’s performance and predict future revenues. Retailers are a good example because December numbers are often much higher than the Summer months.
Using an incorrect run rate could either overstate or understate annualized earnings.
When a company relies too much on high-priced deals, it might have to wait for one or two big sales per year.
Finally, running a rate on the same sales year will not account for any revenue growth. So if you are looking at an average of one time period that has higher than usual revenues because it could grow them during that given time frame, then your annualized number won’t be accurate.
Annual Recurring Revenue
Recurring means that the customer has an ongoing subscription to your product or service. This is different from a one-time purchase because, for example, if you are charging $100 per month but have an annual recurring plan of 12 months at $1,200, it would be Annual Recurring Revenue rather than Monthly Recurring Revenue multiplied by twelve months.
Like MRR (monthly recurring revenue), ARR includes subscription or recurring fees. Products with a one-time cost are excluded from this number, but some companies might exclude variable subscriptions.
Monthly recurring revenue is not always the best way to measure your business’s success because it does not account for days in a month. Actual revenues are often correlated with annual or multi-year subscriptions.
When working with multi-year contracts, it may make sense to only pay commissions on the Annual Recurring Revenue. However, this is not a very effective method for SaaS companies because monthly and yearly plans are more common.
The calculation for ARR is MRR multiplied by 12.
Accrual Accounting
In subscription-based businesses, it is common to use accrual accounting.
In accrual accounting, revenue is recognized as earned and not when the company receives payment.
This accounting method accounts for transactions when they happen, not just when cash changes hands.
When a company is recognized by matching revenues to expenses, it accounts for how much money was made and spent in the present. Click To Tweet
This method gives a more accurate picture of their current financial condition than accounting for future expected revenue.
This is the opposite of cash accounting, which recognizes transactions only when there are actual payments.
A practical example
Here is a table of data to help you understandably understand these metrics.
Let’s analyze the following data set to see how it would work with accrual accounting: Income from the sale of product ABC = $1000.00, Cost of goods sold is 60% ($600). In this example, the cost has already been considered in determining profit before expenses. The gross margin percentage for Product A is 40%. Misc Expenses=$50 – Misc Expense Accountant fee=10%, Utility Bill=$40 -> Total Operating Income-$430.
You can find more information about this data set here.
Billings don’t really make any difference because we use the accrual accounting method. You would include billings as earnings with cash accounting, but since we are using a different accountancy system, we can ignore it.
Annual Run Rate
The first quarter of the year generated $920 in revenue, which means our annual run rate is currently at $3,680. We assume the next three quarters will have a similar performance to this past one.
Annual Recurring Revenue
We use ARR to measure the average amount of subscriptions (or normalized recurring revenue) for one year. So, for example, if someone buys an annual subscription at $40,000 and buys it over four years, then ARR would be $10,000.
Calculate annual recurring revenue by multiplying the monthly fee, $540 * 12, which equals $6,480. Of course, as you book more revenues and your ARR grows over time, it will also change.
It doesn’t matter if your customers are on monthly or yearly plans because we’re working with a per-month value at the end of it all.
Annual Contract Value
There is a lot of confusion surrounding ACV sales because it’s often interpreted differently. It might seem very similar to ARR, but important differences should not be overlooked when evaluating the metric.
It is important to track the ACV sales metrics annually.
ACV sales measure the value of a contract over 12 months. So if someone commits to an annual commitment worth $120,000, they will be paying you for 24 months in total. So if we divide that by 12, it means that each month they are committing themselves to pay $10,000, and so on average, their ACV sales will be 60k.
ACV sales bookings are the total value of term contracts for a given year. ACV sale is an average calculated over one-year periods.
There is a lot of crossover between ARR vs. ACV sales, making them cousins. Average revenue refers to the average yearly subscription price for an individual customer over one year, OR it can refer to just that month’s subscription fee from one client. When calculating these metrics, you should consider two things: how many customers are in your plan AND whether or not they all had subscriptions during the same period.
Total Contract Value
TCV meaning is the total contract value and can be shorter or longer in duration.
It is important to know that TCV bookings not only include recurring revenue. It also considers one-time charges, professional service fees, and other recurring payments.
If a customer commits to a 6-month subscription of $100mo, the TCV would be $600. If they commit for 24 months, your total will be about two grand.
The main purpose of calculating TCV sales is to analyze the total value generated by multi-year contracts. However, ACV sales bookings are more commonly used for analysis purposes for single-year deals because it’s easier to evaluate what customers have paid in advance.
Conclusion
There are many ways to calculate SaaS metrics, but the important thing is that all business units stay on the same page and use consistent calculations.
Calculating an exact value for most metrics depends on how granular you want your measurements. Click To Tweet
Some businesses, like ours, include recurring and one-time fees in the calculation of ACV sales. We prefer to look at all related expenses as part of our final agreement.
Although many people may overlook ACV sales as a valuable metric, it can provide insights into business performance when combined with other metrics. But businesses should not sleep on this statistic and use it by themselves.
