What Is ACV and How Does It Differ from ARR? (With Examples)

By Indeed Editorial Team

Published 16 October 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Businesses that offer subscription services have a variety of ways to measure their economic success. One method they may use is the annual contract value (ACV) calculation, which can help them gauge a company's yearly success. Learning more about this term and how it could affect a company's sales can help you assist a business that wishes to offer its customers a subscription-based payment system. In this article, we offer a definition for ACV, share examples and the equation and discuss how it differs from annual recurring revenue (ARR).

What is ACV?

ACV is a method of analysing a company's income by highlighting each individual contract that a business holds with its customers. To use this metric, you can first create an assumption that all the customer contracts hold the same value to the company. This allows you to establish an average amount of income per customer that you can easily multiply by how many customers the company is currently servicing.

When using the ACV metric, you usually only consider the funds that a company consistently receives every month from one customer. This metric typically doesn't consider income from sources such as one-time setup fees and training or internal customer fulfilment costs. As such, the ACV metric removes administrative costs from the equation. When using this metric, you can typically assume that the income a company receives from those one-time payments ultimately affects its annual profits insubstantially, though this can vary between companies. This is generally because those one-time payments cover operational fees.

Related: What Is Accrued Revenue? (With Definition and Examples)

Advantages of ACV

Using the ACV metric offers useful advantages to help you generate an effective understanding of how much a company makes in a year. This metric empowers you to establish safe assumptions about the income a company is accruing. You can focus on the number of customers an organisation is servicing instead of the specific amount they're paying the business, which can expedite the process of measuring the company's income. This metric also emphasises the importance of focusing on retaining customers with long-term loyalty potential, which can help a company prioritise customer satisfaction as a principle.

If a company offers multiple tiers of pricing to customers, you could establish different broad value categories in which each subscription type fits. Using the ACV metric, you can easily determine which subscription tier provides a business with the most cost-effective income. This information can help you determine which tier a company can focus on in their advertising to gain the most benefit. Ultimately, the ACV provides useful insight into where a business may want to allocate its resources to discover its optimal income.

Related: Revenue vs Turnover: Definitions, Differences and Examples

Comparing ACV and ARR

Another method of measuring a company's annual income is the ARR metric. This metric involves grouping all of a business' recurring income into one category so you can easily determine how much an organisation is making annually. The advantage of this method of measurement is that it allows a company to gauge its revenue at a single point in the year. The ARR metric can help a business make short-term economic decisions under the assumption that its income remains stable through the rest of the year.

The primary differences between the ACV and the ARR metrics are the significance of individual customers in the equation and the ultimate scope at which a company wishes to view its income. Annual contract revenue emphasises the value that individual customers bring to a company. The annual revenue value emphasises the overall value that every customer brings to an organisation, disregarding distinctions in pricing.

Related: What Is Gross Profit Ratio? (Plus How to Calculate It)

Examples of using ACV to measure income

To help you understand this important metric for conceptualising a company's income, you can review the following examples of using ACV to determine a business's yearly revenue, including the advantages of offering each kind of pricing:

Income from monthly subscriptions

Here's an example to help you understand the value of this metric for measuring monthly subscriptions:

A clothing company sends customers fashionable clothing sets every month. The business's main priorities involve offering high-quality customer service to nurture loyal, long-term customers to continue engaging in its service. Because of the individualised nature of its customer relationships, you may want to determine how much discreet value each customer adds to the company's overall income. This can help you determine if the company is optimising its profits while caring for its customers.

The ACV can help you determine how much value each customer provides. Using this metric, a company can determine the amount of individual care it can offer to each customer while still ensuring that it's making a profit from the interaction. For example, averaging the profit a business is making off of each customer can help it decide what level of customisation in clothing choice it can offer to its customers.

Related: Single-Step Income Statement vs. Multi-Step Income Statement

Tiered pricing plans

The ACV metric can also allow a company to distinguish between the profits it receives from multiple tiers of pricing plans. Here's an example of this using the same business:

A clothing company could offer a lower-price tier in which customers receive a shirt and one accessory, while a higher-price tier offers customers a full outfit with three accessories. You could calculate how much customers pay for each tier versus the cost of order fulfilment, assuming that the cost of each order includes the cost of the clothing and shipping.

You may determine from this measurement that the lower-price tier offers a higher profit ratio than the higher-price tier. But after reviewing a company's long-term customers, you may discover that more customers remain loyal to the higher-tier plans. With this information, you could decide that both tiers offer benefits to the company and the customer, so the business can continue providing its customers access to both tiers.

Related: Guide: How to Calculate Gross Monthly Income (With Examples)

Multiple year contracts

A significant benefit of the ACV metric is that it emphasises the value of a customer contract over large periods of time. Here's an example of this in the same fashion business:

You may use the ACV metric to determine that short-term customers ultimately cost a business more than long-term customers who retain their subscription to its service for more than a year. Furthermore, customers that remain loyal for over a year are the most profitable. This can help a company create strategies to encourage customers to remain loyal for multiple years.

Related: How to Become a Certified Management Accountant (With Role)

How to calculate ACV

To help you use the ACV metric, you can review the following steps:

1. Consider the equation

The equation to calculate the ACV metric is as follows:

ACV = Total contract value / Number of years

This equation considers a single customer account at a time. This is useful if you want to determine how much profit a certain tier of pricing offers the company per customer. To scale your usage of this equation, you can include the number of customers the business is servicing, as such:

ACV = (Total contract value / Number of years) x Number of customers

2. Input your numbers

To use the equation, you can simply insert the numbers that are relevant to the company's pricing and customer base. For example, a fashion company charges each customer $2000 biannually for the low-tier plan and $4000 biannually for the high-tier plan. To determine the annual value of each contract for each customer, you can input the appropriate numbers into the equation. The low-tier plan's equation is as follows:

ACV = $2000 / 2

This equals $1000 per year. Meanwhile, the high-tier plan's equation is as follows:

ACV = $4000 / 2

This equals $2000 per year. You can determine from this equation that the high-tier plan offers the company more profits than the low-tier provides.

3. Consider the total profits a company is receiving from both tiers annually

Another useful aspect of the ACV metric is that the business can determine its total profits for both tiers annually. This allows the business to standardise the method by which it conceptualises its pricing by ensuring that the timeframe is the same for all tiers. For example, the company may offer a tier at which customers pay $1000 annually for its fashion service. If the customer commits to a three-year plan instead, they pay $2000. You could conceptualise the annual plan equation as such:

ACV = $1000 / 1

The ACV equals $1000. For the three-year plan, the equation is as such:

ACV = $2000 / 3

This calculation demonstrates that the customer could pay approximately $667 per year. The business could use this form of pricing to encourage customers to remain loyal to its company. In exchange, they receive a discount for its service.

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