What Is Annual Contract Value (ACV)? (Formula and Calculation)
June 13, 2022 Max 6min read
What Is the Annual Contract Value?
Annual contract value definition:
Annual Contract Value in product management is a metric that measures how much money a client brings in each year. Or, to put it in another way, it’s the average yearly revenue per client contract. It’s a critical SaaS measure for selling products with multi-year or annual subscription plans.
First, I state that product managers never consider ACV tracking and computation, even among major SaaS companies that appear to know what they’re doing and how they onboard clients. This produces a great deal of misunderstanding.
One of the essential tasks for a sales leader is collecting and analyzing sales analytics.
The most important sales indicators are customer acquisition cost (CAC), lifetime value (LTV), and churn rate.
ACV is another measure to consider adding to your list. This is an excellent calculation to compare to the others you’ve gathered.
ACV can be used to calculate the financial value of all your client accounts, regardless of whether they involve:
- Monthly memberships
- Plans with varying prices
- Long-term contracts
It’s critical to realize that SaaS businesses can thrive with low or high ACVs. Companies focused on getting more customers may have a lower yearly contract pricing, but they will have more users because of their reduced customer acquisition cost.
B2B companies, on the other hand, may have considerably higher ACVs, but they won’t have as many users because their clients are much more expensive to acquire. To put it another way, a low annual contract value isn’t inherently a bad thing, but it does imply you’ll have to bring in more consumers.
When I learned how many ambiguity and mixed definitions there are to Annual Contract Value, I felt I needed to do some more study about Agile.
Explore the blog for more information about this.
Annual Contract Value vs. Arr:
SaaS enterprises have grown exponentially over the years due to the internet boom. Hence, digitization has increased.
Given this, plus the fact that SaaS clients typically pay a subscription price to access the programs, the measurement of SaaS companies’ performance is via two critical metrics: ACV (annual contract value) and ARR (annual revenue rate) (annual recurring revenue).
Now that we’ve covered the Annual Contract Value let’s look at the ARR.
Annual Recurring Revenue is ARR. Annual Recurring Revenue is a measure that displays the total amount of recurring revenue generated by all of your subscription accounts.
As a result, using ARR, you will be able to calculate the following:
- Annually, calculate the entire dollar worth of your recurring revenue.
- Take one-time fees and levies out of the equation.
- Allows you to calculate your revenue at a specific point in time.
Connections, not one-time sales, are the foundation of the Subscription Economy, yet these relationships are continually changing and reevaluated. New or lost customers, renewals, upgrades, or downgrades are all indicators of relationship changes, and ARR is the most precise way to track them.
These factors impact revenue, but they are difficult to quantify using traditional accounting procedures, particularly GAAP.
The critical difference between these two metrics is that they measure annualized contract values. Despite this, there are some significant distinctions between them.
The most significant difference between ARR and ACV is that ACV is typically used to measure a single account over numerous years, whereas ARR measures multiple accounts.
Annual Contract Value is a metric for calculating the revenue value of a single subscription-based contract.
In contrast, Annual Recurring Revenue is a meter for calculating the revenue value of all subscription-based contracts in the organization.
ACV has a limited scope when used alone because it is not an accurate value. Because of this, it is best utilized in conjunction with other metrics, whereas ARR is a precise figure that can be used to analyze revenue development and improve sales, marketing, and management choices.
The ACV sales formula may differ depending on how the company intends to use the results, but the ARR formula is uniform across all SaaS companies.
Depending on the company’s choices, ACV may include initial or one-time contract charges, but ARR may not have initial or past contract prices.
When calculating ACV and ARR, the values differ, so when should you utilize each metric? To be honest, ACV isn’t a relevant measure, but when combined with other SaaS KPIs, it can provide some vital information. ARR is something you can and should track independently.
Customer A signs a one-year deal for $1000 and pays monthly.
Calculated metrics for Customer A:
ARR = $1000
ACV = $1000
How To Calculate the Annual Contract Value?
No universally accepted formula exists to calculate the annual contract value. Some organizations factor in initial costs like training and onboarding, while others do not.
Use the following formula to compute ACV: ACV = Total contract value ÷ number of years.
For instance, if a customer X signs a five-year yearly subscription contract worth $5000, the Annual Contract Value is:
ACV= 5000/5 = $1000
Also, keep in mind that ACV is computed differently in different industries. On the one hand, a corporation may choose to include set-up and insurance fees, while others may prefer to ignore them.
Your ACV always tells you how many clients you’ll need to meet your next sales goal.
You might be thinking, “Doesn’t ACV look a lot like ARR?” Despite their similarity in sound and appearance, they are two distinct SaaS metrics, as we have highlighted above. Still, perplexed? Let’s look at how to compute ARR.
Divide the entire contract amount by the number of years in the contract.
Divide $4000 (contract cost) by four (number of years) to get an ARR of $1000 per year if a customer signs a four-year contract for $4000. Divide $6000 (contract cost) by two (number of years) for an ARR drop of $3000 if a customer declines to renew a $6000 contract over two years.
I hope this has clarified things.
The method you use to compute ARR influences various factors, including your current pricing strategy and the complexity of your company model. Many elements come into play as a primary indicator for contextualizing your real growth and the momentum at which you may scale.
Netflix and other streaming services are among the most successful subscription businesses. They’ve nailed it when it comes to value-based pricing.
We’ll go over the ARR formula using Netflix’s prices and a customer who buys the Basic plan for $8.99 per month. After three months, if the user upgrades to Premium, the monthly fee climbs to $15.99.
You can see how Netflix’s pricing strategy and customer preferences play a role in these estimates.
To calculate the ARR for Netflix’s complete service, they’d have to account for all account levels, upgrades, downgrades, and cancellations throughout a calendar year.
Netflix would be able to calculate the most accurate picture of its recurring revenue health by using this approach.
What Are Annual Contract Value Examples?
- Your ACV is $12,000 if you have one customer who signed a three-year contract for $36,000.
- Your ACV is also $12,000 if you have 100 customers on a monthly plan paying $1000 per month.
- If a customer signs a $20,000 two-year contract, your Annual Contract Value will be $20,000/2, or $10,000.
- If a client Y chooses a two-year, $300-per-month membership contract? To normalize customer Y’s agreement over a year, you’ll need to utilize the ACV formula as follows:
$300 per year multiplied by 12 months equals $3600.
$3600 x 2 years = $7200 total contract value
As a result, ACV = $7200/2= $3600.
As a result, the main advantage of using yearly contract value as a sales indicator for SaaS companies is that it enables for comparison of different types of recurring revenue accounts.
How can you not think about the company’s health? This measure is what keeps you alive, but most people leave it off their metric list, perhaps because of the confusion between ACV and ARR.
This should clarify things! The average revenue expectation about total revenue assists sales in setting reasonable targets while considering the company’s health.
The annual contract value, or ACV, is the total income generated by a contract over a year. However, running an enterprise-level SaaS company or your business model relies on yearly subscriptions and contracts. You should be familiar with ACV (annual contract value) and ARR (annual recurring revenue).
The average yearly revenue generated from each client contract, excluding fees, is known as the Annual Contract Value (ACV). If a consumer signs a 5-year warranty for $50,000, you may calculate the annual contract value, which comes up to $10,000. It’s the annualized revenue per client contract on average.