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How To Calculate ARPU For SaaS Companies?

HOW TO CALCULATE ARPU

If you are a SaaS business, then here is why it is important for you to know how to calculate ARPU?

  • ARPU helps a SaaS business to analyze its growth potential on a per-customer basis
  • It helps you develop a financial model that enables you to determine your business’ revenue generation capacity
  • Besides ARPU also helps a SaaS business to track its performance

Software-as-a-service (SaaS) and other recurring revenue-based businesses continue to gain popularity, specifically in the technology sector.  Such businesses depend on recurring subscription revenue to sustain their business growth. Accordingly, these companies get a majority of their revenue from existing clients in the form of renewals and upsell. This means that customers who churn after an initial contract purchase can have a huge impact on a company’s long-term financial prospects. 

Thus, it is important for Saas businesses to understand what makes a cloud business successful. To archive this, the businesses need to measure how they perform relative to the key criteria for a great SaaS company. They need to track the key metrics and look to improve on their journey to success.

One such metric is the Average Revenue Per User (ARPU). In this article, we are going to discuss what is ARPU in SaaS and how to calculate ARPU.

ARPU Meaning

ARPU Meaning
Image Source: Free Cash Flow

Average Revenue Per User (ARPU) is one of the key SaaS metrics that measures the average amount of revenue that each user generates over a given period of time. Such a financial metric enables businesses to analyze their growth potential on a per-customer basis. Further, ARPU helps businesses to develop a financial model that enables them to determine their revenue generation capacity. 

Note that the businesses calculate this metric taking into account its active users. Accordingly, the ARPU calculation is performed by dividing total revenue by average users during a specific period. 

Typically, businesses with a recurring revenue model such as subscription companies, SaaS, in particular, use this metric to determine their growth. Since ARPU plays a key role in determining business growth, it is one of the key metrics that SaaS businesses use to track their performance.

Note that customers make repeat purchases of the same product and also buy product upgrades during their lifetime. The SaaS business may offer them discounts, free access, or plan downgrades in order to retain them. All these actions have a great impact on the Average Revenue Per User. 

As a result, it is important for a SaaS business to track its ARPU over time. Moreover, such a  metric is also important to make revenue and growth projections for the underlying SaaS business.

Why is ARPU Important For A SaaS Business? 

1. Analyse Growth Potential

The average revenue per unit enables a SaaS business to analyze its revenue generation capacity and growth at the per-unit level. Such a metric helps various stakeholders of the business to identify which products that are high or low revenue-generators.

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ARPU is a useful metric for businesses that are particularly in the telecommunications, media industries, and SaaS-based businesses. That is businesses that depend on subscribers or users for revenues and profits.

Though, GAAP does not necessitate subscriber-based businesses to evaluate and track ARPU as a financial metric. However, various stakeholders of a subscription-based business track such a metric to understand the firm’s capability to generate revenues and its growth potential.

2. Take Key Strategic Decisions

ARPU as a financial metric helps a SaaS business to identify customer trends in a specific segment as compared to the other segments. This metric enables a business to understand what are the different price points at which customers are purchasing more products relative to the other price levels.

Further, it also allows executives to recognize the various trends with regard to product upsell and down-sell.  As a result, all such trends help a SaaS business become more efficient. That’s because the managers can take important strategic decisions based on such trend analysis. These decisions may include which products to sell more and which products to cease.

On the other hand, ARPU as a financial metric helps startup SaaS businesses more as compared to the ones that are already well-established. That’s because startups typically have declining ARPU as they offer discounts to attract signups. In such a case, having declining ARPU numbers is completely fine till the time the startup is generating new customers. However, at a later stage, such a firm needs to transit from focusing on subscriber growth to revenue growth.

3. Make Projections

Another important aspect of evaluating and tracking ARPU is that it enables a business to forecast the future growth potential of a business. As a result, the business can plan for both the long term and the short term. 

How? Well, ARPU projections can help executives to understand who are the higher paying customers or customers responsible for generating a major chunk of revenues for the business.

By determining such future trends and patterns, business managers can focus on increasing the Monthly Recurring Revenue (MRR) growth through higher paying customers. Note that higher ARPU enhances the Customer Lifetime Value (LTV) goals of a SaaS business. LTV of a customer is the total dollar amount a business is expected to receive from an individual customer over the life of his account with the SaaS product. 

Note that customers with higher ARPU are the ones that are recurring in nature. As a result, it is important for businesses to retain such customers. Such efforts would ensure that the SaaS business is on the path of growth that is extremely essential for its long-term success.

4. Undertake Comparisons

Analyzing ARPU as a financial metric all alone can be misleading for subscription-based businesses. Such a metric when tracked alone may seem to indicate positive growth, though the business may be losing customers and witness declining revenues.

Therefore, it is important for SaaS businesses to track ARPU along with other key metrics like Customer Lifetime Value(CLC), Customer Acquisition Cost ratio(CAC), Customer Lifetime Value (LTV), MRR, ARR, Churn Rate, and the like. 

5. Make Pricing Decisions

ARPU numbers enable a SaaS business to price its products correctly. Say, for instance, a SaaS business with increasing revenues and number of subscribers may seem like a growing business. However, one needs to track ARPU numbers to understand the real position of the business.

Increasing revenues and subscribers but a stable ARPU may indicate that the SaaS products sold by the business are not well priced. In other words, such products are underpriced. In fact, having an ARPU lesser than the cost of acquiring new customers may also indicate the same. 

All these trends indicate that a business is losing money on every new customer. Consequently, the SaaS business may decide to focus on other profitable demographics or explore new marketing channels and tactics.

ARPU Formula

ARPU Formula
Image Source: Free Cash Flow

As mentioned earlier, the Average Revenue Per User (ARPU) is nothing but total revenue arising from the active users of a SaaS business divided by the total number of customers giving rise to such revenue. 

The following are the components that form a part of the Average Revenue Per User of a SaaS business.

  • Monthly Recurring Revenue (MRR) 

MRR is a measure of how much revenue a business generates from the subscription payments that subscribers or customers pay each month. It is a growth metric that enables SaaS or subscription-based companies to forecast their expected revenue for a given month. 

  • Account Upgrades

Account upgrades form a part of MRR and are sometimes referred to as Expansion MRR. These are the recurring revenues that a SaaS business generates as a result of additional sales to its existing customers in a given month. It is a performance metric that measures revenue growth from existing customer upgrades or added services. In other words, account upgrades are the difference between the value of the old plan and the upgraded plan.

  • Account Downgrades

Account Downgrades also form a part of MRR and are sometimes referred to as Contraction MRR. It represents the decrease in the monthly recurring revenues of a SaaS business. The decline in MRR happens when the existing customers renounce or reduce the scope of their current subscription or service in a given month. Thus, Account Downgrades is a performance metric that measures revenue change from existing customers downgrading or applying discounts. It is nothing but the difference between the value of the old plan and the downgraded plan.

  • Churned MRR

Churned MRR is also called Canceled MRR. It refers to the monthly recurring revenues lost as a result of the existing customers giving up on their product or service subscription altogether. It may include non-renewals, cancelation of customer subscriptions, etc. Thus, Canceled MRR is a performance metric that measures the change between MRR lost due to downgrades and MRR added from expansion revenue. This is an important figure in understanding the areas where a business can improve despite having an MRR.

  • Total Paying Customers

Total Paying Customers refers to all customers who have paid for the SaaS service within the month and have active accounts. In case a SaaS business has certain accounts that are “free users”, they should not form a part of the ARPU calculation. This is because such accounts are not generating any revenues for the SaaS business.

Thus ARPU formula is:

Average Revenue Per User (ARPU) = Total MRR/Total Number of Active Customers

Or

Average Revenue Per User (ARPU) = (Beginning MRR + Expansion MRR – Contraction MRR – Churned MRR)/Total Number of Active Customers

How To Calculate ARPU For A SaaS Business?

Let’s consider an example to understand the ARPU calculation of a SaaS business. Suppose ‘Zootin’ is a cloud-based customer relationship management (CRM) software that helps businesses in generating and tracking leads. It wants to calculate the ARPU for the month of December 2021. The following are the key revenue metrics of ‘Zootin’ for December 2021.

Key Revenue Metrics of Zootin for December 2021
Begining MRR$500
Expansion MRR$200
Contraction MRR$100
Churned MRR$50
Total Active Customers20
Calculation of ARPU
ARPU FormulaTotal MRR/Total Active Users
Total MRRBeginning MRR + Expansion MRR – Contraction MRR – Churned MRR
Total Active Users20
ARPU$28

As we can see, the Average Revenue Per User of ‘Zootin’ for the month of December 2021 is $43. This is nothing but the sum of total MRR divided by the total active customers of ‘Zootin’ for the month of December.

Using the formulas above, the Total MRR for ‘Zootin’ for December 2021 is $550 ($500 + $200 – $100 – $50). The total active customers for December 2021 were 20. As a result, the ARPU for December 2021 was $28 ($550/20).

How Do You Interpret ARPU For A SaaS Business? 

The past ARPU trend of a SaaS business enables it to take key strategic decisions. Such decisions may include increasing the sales of high-paying SaaS products and reducing or ceasing the sales of products generating lower revenues. Also, it helps a business to know its growth potential and make projections that help in enhancing customer retention.

Thus, changes in ARPU also bring about changes in other key SaaS metrics. These include Customer Lifetime Value (LTV), MRR, profitability, and efficiency.

1. Monthly Recurring Revenue (MRR)

The ARPU of a SaaS business has a direct impact on its MRR. The monthly recurring revenues of a business increase when its individual customers contribute more revenue each month. This may result from an increase in upsells or account upgrades and new customers subscribing to the SaaS products each month. 

2. Customer Lifetime Value (LTV)

Customer Lifetime Value (LTV) is nothing but the total dollar amount a SaaS business is likely to receive from an individual customer over the life of their account with the SaaS product. It is a SaaS metric that measures how well a SaaS business monetizes its products (MRR) with how well it retains its customers (MRR Churn). 

Thus, an increase in MRR or a decrease in MRR churn or both can help a business enhance its LTV. This showcases that increasing ARPU also increases the LTV of a business.

3. Product Pricing

ARPU also indicates whether a SaaS business is charging the correct price for its products. For instance, a declining ARPU indicates that the business is not attracting a good price from a few of its customer segments. In other words, it means that the customers are deriving more value out of the SaaS product as compared to the product pricing. As a result, the business should charge more price for the enhanced value it is providing to the customers via its product.

4. Sales Efficiency

The ARPU of a SaaS business also reflects the efficiency of its sales team. As the sales and marketing teams become adept in their sales and marketing pitches, the ARPU of a business improves. 

Increasing ARPU indicates that the SaaS business has relevant customers who want to invest in the value proposition that its product is offering. Such insights help the sales and marketing teams of the SaaS business to have efficient systems in place.

Furthermore, insights on ARPU of different product segments may enable executives to determine the trends in cross-selling and up-selling.

How To Optimize ARPU For A SaaS Business?

As mentioned earlier, the ARPU of a SaaS business helps the business in understanding the trends with regards to the products and the pricing plans. 

Such insights enable a business to make key strategic decisions like improving the product pricing, enhancing sales of popular products or plans, ceasing the non-performing products or plans, etc.

Thus, optimizing the ARPU is extremely important for a SaaS business. The following are the ways in which a SaaS business can optimize its ARPU.

1. Optimizing Product

It is extremely important for a business to determine the growth potential of its SaaS product on a continuous basis. The executives need to determine the strategies via which they can enhance the product’s growth potential. Such strategies may include expanding geographically, adding new features, diversifying product segments, or providing new services.

Note that each opportunity that has the potential of adding value to the existing SaaS product is a way through which a business can increase its ARPU.

For instance, Salesforce is a SaaS-based company that initially came up with a CRM. Then, it came up with its Customer Success Platform to tie up sales, service, marketing, analytics, community, and mobile apps. The customers who are loyal to salesforce help the company add to their business by sticking to Salesforce and the SaaS services that it offers. This helps the business in enhancing its ARPU numbers.

2. Improving Pricing

The simplest way to enhance ARPU numbers for a SaaS business is to increase the pricing of its product. However, such a strategic initiative must be taken after taking into consideration a host of factors including the needs of the customers.

It is important for a SaaS business to intimate the customers beforehand about the price increase. Further, it must also explain to customers the value addition they will get in return for the increase in price.

It is important for a SaaS business to understand that a strategic step such as an increase in the price of the product may have dire consequences. For instance, customers may switch to alternative products.

One way to overcome such a consequence is to go for a variable pricing model. Such a model helps a SaaS business to offers different features at different prices. For instance, they can come up with basic, standard, and premium plans offering different features at varied prices. Such a scalable pricing model helps a SaaS business to increase its ARPU as well as keep customer needs into consideration.

3. Account Upgrades

Another way via which a SaaS business can optimize its ARPU is to offer account upgrades, add-ons, and cross-sells. This way each customer would subscribe to a plan as per their need. Say, for instance, a customer of a CRM SaaS product may prefer taking a basic plan and purchasing a customer support add-on for the initial installation and maintenance. 

There might be another customer who would prefer buying the premium package or an enterprise-level plan as he runs a big team.

Customers would keep renewing their subscriptions or purchasing add-ons depending upon the level of trust they place in the SaaS product. Once they have trust in the product, they will not look for alternatives and stay loyal to the product.

4. Bundled Features

Many SaaS businesses prefer giving customers product features and add-ons in bundles. They have separate plans depending upon the size of the teams or customer requirements.

Say for instance a solopreneur may buy a standard license of cloud-based accounting software. Since he is the only one running the show, he may update expenses, incomes, and other accounting transactions into the software on his own.

On the other hand, a medium-sized business having a team of executives may require an enterprise-level package. That’s because such a package has the option to add multiple users who can use the cloud-based accounting application at the same time.

This is an effective way of improving the ARPU of a SaaS business. That’s because it is serving customers with product features as per their needs and requirements.

5. Minimize Customer Churn rate

Churn rate refers to the customers who abandon using the SaaS application in a given period of time. A high churn rate would mean declining ARPU for the SaaS business.

A SaaS business must always aim to reduce its Churn Rate. It should make efforts to retain customers for a long period of time by enhancing product features, optimizing pricing, enhancing customer support, and overall experience.

Note that loyal customers would keep on renewing their subscriptions. And this would result in increasing the ARPU of the SaaS business.

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