The software as a service (SaaS) business model operates differently from most. Unlike traditional retail, your customers get to access your company's software for the duration of their contract. If they're happy with it, they can renew or increase the services they get.
When the subscription model is your company's bread and butter, you rely on recurring revenue, which is predictable and easy to track. Two recurring revenue key performance indicators (KPIs) that are particularly important for SaaS companies are annual recurring revenue (ARR) and monthly recurring revenue (MRR). Take a closer look at how SaaS ARR and MRR work and how your company can make the most of them.
What Is Recurring Revenue?
Recurring revenue is income that your company expects to receive at regular intervals. When you have a recurring revenue business model, your customers typically pay you for access to your service or product, not for ownership of the product itself.
In the past, customers typically purchased software outright. They would pay the full price of the software program upfront; Once the customer purchased the software, that was it. The software company wouldn't get more from that particular customer until a new version of the software came out and the customer decided to upgrade.
The SaaS model is more common and benefits both customers and companies. If your company uses a SaaS model, your customers pay a regular subscription fee to access the program. They can use the software as long as their subscription is active. If you update the program, the customer automatically gets the updates.
Instead of paying your company a flat fee upfront, the customer pays monthly, quarterly, or annually for their subscription. You can count on that revenue to come in for as long as the subscription is active.
Depending on your software program, a customer might add features or services to their subscription, increasing the recurring revenue amount. They can also cancel their subscription, meaning your company loses some of its recurring revenue.
You can measure recurring revenue based on how frequently your company receives it. In SaaS, MRR and ARR are common metrics.
What Is Annual Recurring Revenue (ARR) in SaaS?
ARR is the revenue your company expects to get from its customers every year. It's the value of recurring revenue contracts during one year. Typically, SaaS companies that offer customers contracts of at least one year use ARR vs. MRR. Since more companies let customers subscribe on a month-to-month basis, ARR isn't as common as MRR.
When you calculate ARR, you can look at several components:
Revenue from new customers: If you sign up new customers who agree to one-year or longer contracts, the revenue you get from them should fall under the “new ARR” metric.
Revenue from renewing customers: Revenue from customers who renew contracts and who continue to receive the same service level fall under the “renewing ARR” metric.
Decrease in revenue from customers who downgrade: Your company's ARR can shrink if customers choose to reduce their service level.
Expansion revenue from customers who upgrade: ARR can increase if renewing customers add more services.
Revenue churn: Revenue churn measures the customers your company lost, such as customers who don't renew at all.
ARR reveals several important pieces of information about your company's financial health. You can use ARR to:
Report expansion and contraction: ARR lets you report on whether existing customers are adding to their service packages or reducing the size and cost of their packages.
Report growth: With ARR, you can track how many new contracts you sign on and how those new customers affect your company's growth.
Evaluate average selling price trends: You can use ARR to assess trends in average selling price (ASP). Your software might cost differently in different markets. With ARR, you can calculate the average subscription price, which helps you determine how to price the product moving forward.
Create cohort reports: You can use ARR to evaluate and create cohort reports, giving you insight into how your customers behave based on company size, location, and market changes.
What Is Monthly Recurring Revenue (MRR) in SaaS?
If ARR is the recurring revenue your company expects each year, MRR is the recurring revenue you expect every month. MRR refers to the regular revenue your company brings in, such as monthly subscription fees. It's not necessarily your company's total revenue, unless all of your revenue comes from subscriptions and recurring charges.
MRR can make your company particularly attractive to investors. The metric reveals whether or not your company has a continual, sustainable source of income. You can also use MRR to predict your company's future growth.
ARR and MRR SaaS metrics types include:
New: New MRR or ARR comes exclusively from new customers. The revenue amount can vary based on the type of new customers your business gets. You might sign up several new customers for your company's highest subscription tier during one month or year. That means your new MRR will be higher than your existing MRR. You might want to know why customers are now signing up for the higher service tiers.
Renewing: Renewing ARR or MRR is from customers who decide to continue their service contracts. The size of your renewing recurring revenue metrics can help you determine if customers are happy with your product offerings or not.
Expansion: Expansion ARR or MRR comes from customers who add on services or upgrade their subscriptions. It's a big green flag that lets you know your business is doing something right. It can also signal that things are going well in the market, as customers are willing to spend more.
Contraction: On the flip side, contraction ARR or MRR reveals that customers are reducing their subscriptions or signing up for fewer services. Contraction is normal, but too much of it can mean that something's up in the market or that customers don't have the extra cash to spend on your services.
Churn: Churn MRR or ARR is a critical metric to monitor, as it shows you how many customers are canceling or deciding not to renew with your company. Keeping tabs on your company's churn rate lets you course-correct as needed. It could be that customers are leaving because the subscription price is too high or because they need something more from their software. Your churn rate could be high because you don't offer an auto-renew option or it's too complicated for customers to renew their subscriptions.
Why Should You Care About ARR and MRR?
ARR and MRR are two of the most important SaaS metrics. Your SaaS company relies on subscriptions for its survival. You need to regularly sign up new customers and have existing customers continue their subscriptions. You also need to know how much revenue you're losing due to churn or contraction.
Knowing your ARR or MRR lets you make critical operational decisions and evaluate your product's quality. Tracking ARR or MRR also lets you evaluate your team's efficiency.
Take a look at the importance of ARR and MRR in several departments:
Customer service: The strength of your company's customer service team directly influences your customer acquisition, retention, and expansion rates. As your business grows, the more expansion and retention revenue you have, the better. If the customer service team knows to encourage upgrades, your company will see an uptick in expansion MRR or ARR. Customer service also affects churn rates. Great service can make or break a customer's decision to renew or cancel.
Sales: Your sales team turns leads into customers, affecting your new customer MRR or ARR. You can develop a compensation plan that gives sales reps an incentive to upsell or sign up more customers than their quotas require to boost new recurring revenue.
Marketing: The marketing team finds the leads that the sales team then converts. Your ARR and MRR depend in many ways on the strength of your company's branding and marketing efforts.
Research and development: ARR and MRR show you what's working and what's not as effective. Your research and development departments can use that information to focus on developing new products or service features.
Engineering: How well your SaaS product is engineered affects renewal rates and expansion. The more user-friendly your software, the more likely customers will keep using it or use it even more.
ARR vs. MRR: Which Is Right for Your Company?
Does it matter whether you use ARR or MRR? In many ways, yes. ARR might be the better metric for some SaaS businesses to track, while MRR makes sense for others. It all comes down to your business structure.
If your SaaS business relies on high volumes of month-to-month contracts and develops monthly forecasts, stick with MRR. If you have annual or multi-year contracts or if your annual contract values are high, use ARR.
How Can You Calculate ARR and MRR?
While ARR shows your annual recurring revenue and MRR is your monthly recurring revenue, the formula you use to calculate the metrics is the same. The key difference is whether you're using monthly numbers or yearly ones.
The formula looks like this:
Beginning + New Business + Expansion - Contraction - Churn = Total
Let's break that formula down further:
Beginning ARR or MRR: The beginning recurring revenue is how much you start the year or month with. Using ARR, you might begin the year with $300,000 in recurring revenue. For MRR, your beginning recurring revenue might be $25,000.
New Business ARR or MRR: New business recurring revenue reflects the number of customers you onboard in a year or month and the value of their contracts. You might sign up 10 new annual customers, paying $5,000 per year. Your new business ARR is $50,000 (10 times $5,000). If you use MRR, you might sign up one new customer who pays $1,000 monthly. Your new business MRR is $1,000.
Expansion ARR or MRR: Expansion ARR or MRR is the new annual or monthly value of any service upgrades. With ARR, two customers decide to add on to their service, boosting their annual subscription by $500. Your expansion ARR is $1,000. If you use MRR, you might have three monthly customers decide to increase their service, paying an extra $300 each. Your expansion MRR is $900.
Contraction ARR or MRR: Customers might decide to reduce their service, too. Let's say an annual customer reduces the value of their subscription by $500. You'd have to subtract $500 from your total ARR. If you use MRR, a monthly customer might switch to a lower-tier service package, which costs $100 less per month. You'd need to subtract $100 from your MRR total.
Churned ARR or MRR: If customers cancel or decide not to renew, you must subtract their subscription value from your ARR or MRR. Five customers might cancel annual subscriptions worth $5,000. You then subtract $25,000 (five times $5,000) from your total ARR. If you lose one monthly customer who paid $1,000 per month, you'd subtract $1,000 from your MRR.
Tracking your ARR or MRR helps you see if your company is growing or contracting. Ideally, the MRR or ARR will increase over time. While there's no set ARR growth rate or MRR growth rate, you want to see the value of your recurring revenue climb.
Since SaaS companies depend on recurring revenue, a good ARR or MRR benchmark will be as high as possible. Remember that your exact MRR or ARR benchmark depends on company size, product offering, and market demand. You can look at your competitors to see if you're hitting the ideal target or not.
How Do You Improve and Increase ARR and MRR?
If your ARR or MRR isn't where you want it to be, you can take steps to increase or improve ARR or MRR. Focus on two areas to improve MRR or ARR.
The first area is revenue amounts. The more revenue your company brings in, the higher your ARR or MRR. You can increase MRR or ARR by doing any of the following:
Upselling existing customers
Acquiring new customers
Switching to an auto-renew subscription model
Limiting free trials or freemium services
The second area to focus on when increasing or improving ARR or MRR is
. You can reduce churn by doing the following:
Strengthening your customer service team
Continually improving your product
Focusing on retention efforts
Easing the renewal process
Developing products customers can't live without
KPI Sense Can Help Your SaaS Company Strategize and Grow
Metrics matter when you run a SaaS company. Check out the “Metrics that Matter” ebook to learn more about the crucial metrics for B2B SaaS businesses. If you want to learn more about how the KPI Sense platform can help your company grow, contact us today to set up a chat. Learn about the key performance indicators that inform your business decisions.