Annual contract value (ACV) vs. annual recurring revenue (ARR)

ACV vs ARR:

ACV (Annual Contract Value) refers to the average revenue generated from a single customer’s annual contract, while ARR (Annual Recurring Revenue) represents the total revenue expected from all active contracts on an annual basis.

Annual contract value (ACV) vs. annual recurring revenue (ARR): What’s the difference? The distinction between ACV and ARR is in how revenue is captured. ACV is the overall value of a contract throughout its duration, whereas ARR is the income from a subscription-based model captured in a particular year.

Knowing the differences between key metrics is critical for your business to measure revenue correctly and make educated decisions about future development strategies. ACV and ARR are essential metrics in telecoms and software as a service (SaaS) corporations.

Although these concepts may sound similar, significant distinctions between them merit exploration. So, how do ACV and ARR differ? This article answers that exact question, so read on to learn more!

Article outline:

• What is ACV?
• What is ARR?
• ACV vs. ARR: What’s the difference?
• ACV pros and cons
• ARR pros and cons
• How to calculate ACV 
• How to calculate ARR

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What is ACV?

ACV is a metric that businesses use to calculate the total yearly income a customer’s contract generates. It’s frequently adopted in SaaS and telecoms, where clients sign contracts for specific periods.

ACV considers the total contract value, including recurring charges, upgrades, or add-ons. Your business can use this measure to monitor current income sources and project future growth. ACV may also assist you in identifying areas where you can strengthen your customer retention efforts and boost your customers’ lifetime value.

Your business can maximize its revenue potential by using ACV data to inform pricing, product development, and marketing strategy decisions.

What is ARR?

ARR is a business measure that calculates the predictable, recurring revenue that a company expects to generate over a year. This metric considers all types of regular income, such as subscriptions, maintenance fees, and other ongoing payments.

If your organization relies on recurring income sources, tracking this measure is crucial to evaluate the company’s long-term financial health and formulate development strategies. You can use ARR to indicate how successfully a company’s products and services sell and promote.

ACV vs. ARR: What’s the difference?

ACV and ARR differ in their methods of computation and application. ACV counts the total revenue of all contracts signed during a year, whereas ARR measures a firm’s anticipated annual income from recurring revenue streams.

Although both indicators help understand a company’s financial success, they serve different functions and might offer various interpretations of the same data. ACV, for instance, is frequently used to gauge a business’s capacity to gain new clients and increase sales. ARR, conversely, is used to measure a company’s revenue streams’ consistency and predictability, particularly those derived from subscriptions or recurring services.

Additionally, while ACV can give an idea of a company’s revenue at a single point, ARR considers fluctuations in customer behavior and subscription rates to provide a complete picture of the company’s financial health and growth potential.

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ACV pros and cons

ACV can be beneficial in giving a clear idea of revenue and growth possibilities, but it has its limitations and downsides. Let’s explore the benefits and drawbacks of utilizing ACV as a business key performance indicator (KPI).

Pros:

• Tracks sales and marketing initiatives:Calculating each customer’s typical revenue enables your business to evaluate the efficacy of sales and marketing campaigns.
• Improves budgeting decisions: It can assist you in tracking your company’s annual revenue and identifying trends over time to make better planning and budgeting decisions.
• Fosters better customer retention strategies:It motivates your team to invest in customer retention efforts by revealing the true worth of their long-term contracts with clients.
• Measures against competitor performance: It enables you to compare your company’s growth potential with competitors by measuring revenue solely from new customers, renewals, or upgrades in existing contracts.
• Provides a clear, straightforward metric:It gives you a simple metric that’s easy to explain to investors, employees, and customers.

Cons:

• Time-consuming to calculate:Gathering the data necessary to calculate ACV correctly may take a lot of time and effort.
• Unaccountable for one-time purchases:ACV is based on recurring revenue, so it might not accurately reflect the effect of past purchases or non-recurring revenue streams.
• Partial measure of business success:ACV only offers a partial picture of a company’s overall success and should be used with other financial metrics.
• Nonconsiderations in customer behavior:ACV typically assumes that customers will renew their contracts at the same rate regardless of changing market circumstances or consumer behavior.

ARR pros and cons

ARR gives income streams consistency and predictability, but conversely, it could make it harder for a business to evolve with the times. Let’s examine the perks and drawbacks of using an ARR model in more detail and determine whether it suits your company’s needs.

Pros

• Stable and Predictable Income:Being a subscription-based business model, ARR offers a steady flow of income for companies. This metric aids your organization in creating long-term financial plans and budgets.
• Higher Valuation:Investors and stakeholders often place a more excellent value on businesses that use an ARR strategy. That’s because a steady income stream increases investor trust in a company’s financial stability.
• Customer Retention: The ARR subscription-based business model simplifies keeping customers because they’ve already invested in your good or service. It also allows businesses to upsell and cross-sell to current clients, increasing income.
• Improved Product Development:An ARR model helps your company better forecast its income streams, enabling it to devote more resources to product development. You can devote resources to enhancing your current goods and services and creating new ones, boosting client retention and happiness.
• Better Financial Planning:ARR enables your company to more accurately anticipate its future revenue and costs, allowing it to manage its finances better. Better decision-making, more profits, and excellent overall financial health can result from this.

Cons

• Higher pressure to retain customers:The stakes are higher for client retention when your company’s income is primarily dependent on repeat purchases. Because losing consumers may significantly affect an organization’s ARR, it may leave less room for trial and error.
• Difficulty in adjusting pricing:Price adjustments might be tough to implement under the ARR model, since it relies on steady and reliable revenue. Any price changes will need to be phased in gradually and methodically to avoid upsetting the regular flow of income.
• Limited flexibility:The focus on recurring income may limit your company’s ability to pivot or change direction quickly. It could be challenging for the business to quickly adapt to the market’s need for a new good or service without jeopardizing its current income stream.

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How to calculate ACV

Determining the ACV involves a few steps. You must first calculate the total cost of all contracts signed throughout the previous year. This method covers both new contracts and contract extensions. After calculating the sum, divide it by the years the contracts are valid.

ACV = total contract value ÷ number of years

For example, If the annualized contract value is $1 million and the total contracts signed that year have a two-year term, the ACV is $500,000.

It’s also common to determine the ACV per client rather than for the entire business. This approach can offer insightful information on the worth of particular clients and the general health of the customer base.

How to calculate ARR

There are other ways to figure up ARR, but one popular method is to add up all the recurring income from subscriptions, maintenance fees, and other sources over a year. This method entails eliminating one-time charges and other non-recurring income sources. After you obtain this figure, divide it by the overall number of clients or subscribers you have to determine the average ARR per client.

For instance, a software company with 500 clients, each paying an average of $100 monthly for a subscription, would generate $50,000 in MRR. This product would result in a 12-month ARR for the business of $600,000 and yields an ARR per customer of $1,200 when you divide the amount by the total number of clients (500).

This method provides a ballpark figure for the total revenue you anticipate receiving from that customer throughout their relationship with your business.

Improve your ACV and ARR with WebFX

By putting into practice tried-and-true tactics that boost customer retention and upsell chances, our team of specialists can assist you in maximizing your ACV.

We can increase your ARR and achieve sustainable growth for your company by strongly emphasizing long-term client connections. We’ll fulfill your ACV and ARR objectives with our data-driven methodology and individualized solutions.

Contact us online or call 888-601-5359 to learn more about how we can help you improve your bottom line and drive revenue growth.