In this article, we will take a closer look at how to measure and analyze the Revenue and Costs of a subscription business.
When it comes to measuring revenue, there are at least four dimensions that are relevant to consider. These are Recurring Revenue, Periodic Revenue, Average Revenue and Lifetime Revenue. The latter was briefly summarized in the first part of this article series so here we will focus on the other three.
The recurring revenue is the total value of the subscriber base at a specific time, calculated over a period of time, for example per month or per year. When measured on a monthly basis, the revenue is called MRR (Monthly Recurring Revenue) and for years it is called ARR (Annual Recurring Revenue). For most subscription businesses, MRR is probably most relevant. This is the total monthly value of the subscription base right now. As an example, if we have 1,000 subscribers who all pay 100 per month, we have an MRR of 100,000.
MRR can be a powerful concept for understanding the change in value of the base. For example, one can describe the change in MRR between two months according to:
= MRR (month 1)
+ Revenue from new customers
+ Increased revenue from existing customers
– Lost revenue from churned customers
= MRR (month 2).
Revenue from churned customers is often referred to as revenue churn. Measuring revenue churn can be a good way to understanding changes in the base, but is mainly relevant if you have products and offers which differ greatly in price within the base. If most subscriptions have the same price, then you might as well look at pure volume measures to understand the change month to month.
Periodic Revenue is the resulting revenue for a specific fixed period, most commonly monthly and yearly. For example “March 2019" or "full year 2018". The link to MRR and ARR (or other recurring revenue) is obviously close. If we have a constant MRR of X over a certain period that includes a specific month, then the periodic revenue that month is equal to the MRR. In practice, however, MRR varies directly if a change in the base occurs, which means that MRR is rarely exactly the same as periodic revenue.
Periodic revenue is important because it is what you'll find in your financial reports and your income statement. It's what is ultimately compared with the corresponding costs, to understand if we hit the monthly or yearly numbers.
Average Revenue is simply the average revenue we get from our subscribers, per time period, often monthly. This revenue is often referred to as ARPU (Average Revenue Per User). It is important to consider which volume you measure when you calculate the average revenue. It's common to use the current balance of subscribers and in this case: Volume * ARPU = MRR. If, on the other hand, you want to calculate average revenue over a month (i.e. compared to a period revenue), which is sometimes relevant, then we must instead divide by the average volume of subscriber over the same time period.
When calculating average revenue, it is important to understand how to handle trial offers, non-paying subscribers and discount rates. In short, there is no right answer, but your have to decide and be consistent. One way to go is to distinguish between ARPU and ARPPU, which is short for Average Revenue Per Paid User.
Average revenue is important to understand the recurring value we receive from each subscriber. It shows if we manage to raise prices, get our subscribers to choose more expensive products or lower their discounts.
If you work with products with longer subscription periods and a higher value per month or year, it may be relevant to look at contract value, also called TCV (Total Contract Value). This concept shows the total (minimum) value we will get from each new sale. We believe that this concept should be used primarily to assess sales efforts, if one sees a need for that.
How do we measure the cost side in a smart way? It is both simpler and more complicated than measuring revenue. The simple thing about revenue is that it can easily be attributed to different customers and products. However, revenue is difficult to predict in the future. For the cost side, we often know with certainty that they will occur at a certain point in time. However, costs are more difficult to relate to specific customers, products or revenue streams.
When it comes to measuring the costs of a subscription business, our suggestion is to work in three levels: Acquisition costs, indirect costs for the subscription business, and finally, all other costs. From each of these levels, we can then calculate a contribution margin.
Acquisition costs are costs that can be attributed to specific customers, specific sales channels or sales activities. For example, it may be a commission to a sales company to acquire new subscribers or the cost of social media advertisement. If you measure this per subscription or customer then you will find the CPO (Cost Per Order) or CAC (Customer Acquisition Cost). CAC is perfect to compare with the previously discussed lifetime revenue to understand what contribution is left over from direct selling costs (which should cover everything else).
Indirect costs for the subscription business are all other costs associated with running the subscription business. It can be staff, customer service, technology, and more. The contribution at this level is a gross contribution which must be positive in order to cover the company's other costs. It is not uncommon to be measured on this contribution level as the person responsible for a subscription business.
Other costs are all other costs, which are not included above. What these costs are will be very specific for you company and your industry. The contribution after this level is operating profit or EBITA. This part is not really relevant to measure in a subscription business. However, it is important to remember that the gross contribution we see in the subscription business should cover this entire cost base – together with our other revenue streams of course.
This was a brief summary on how to measure Revenue and Costs. The next and final article in this series will discuss important considerations when measuring and analyzing your subscription business.