What Is Annual Contract Value (ACV) And How Should You Use It?

What Is Annual Contract Value (ACV) And How Should You Use It?

Three-letter acronyms abound in the four-letter SaaS world: LTV, CAC, MRR, ROI, etc. Today, we’ll examine annual contract value (ACV), a sometimes misunderstood but extremely helpful statistic in the world of software as a service (SaaS). In the same way that ARR may reveal how well your SaaS company is doing, so can the value of yearly contracts. There is a lot of conflicting data out there on how to assess ACV since nearly no one can agree on a single method to do it. We’d want to set the record straight. First, let’s define ACV, then we’ll look at some sample calculations for a SaaS company, and last, we’ll discuss how to utilize ACV as a decision-making tool.

What is annual contract value (ACV)

The ACV of a contract is the total amount of money earned from a single client over the course of a year. Because of its applicability to subscription-based business models, ACV is of particular interest to SaaS providers.

Customer lifetime value (LTV) and customer acquisition cost (CAC) are only two of several sales metrics already available to SaaS companies. For what reason should we take the ACV seriously?

The annual contract value (ACV) is not a perfect statistic on its own. ACV alone may not be enough to influence sales, marketing, or price decisions, but it may be when paired with other key sales metrics.

Netflix and Hulu, which provide inexpensive consumer subscriptions, have a lower yearly contract value since they don’t have to actively pursue new users. In contrast, B2B firms may increase their CAC spending yet maintain a greater ACV per customer.

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A common misunderstanding is that ACV equals ARR, or annual recurring revenue. Annualized Contract Value (ACV) and Annualized Recurring Revenue (ARR) are, of course, each a 12-month variant of MRR. Differences between ACV and ARR are common since there is no agreed-upon method for calculating ACV but there is for calculating ARR.

The ACV measure, for example, summarizes the yearly income from a single multi-year contract. ARR, on the other hand, would spread the value of each annual contract out over a full year.

Second, its ACV may be adjusted upward to incorporate growth revenue (from upsells and cross-sales) and one-time training or set-up expenses. Instead, the total income is determined between two defined dates, hence the billing structure plays no role in calculating ARR.

How to calculate annual contract value (ACV)

The method used to determine ACV is simple. Here are the measures to take: 

  • This involves cataloging any fees that will be due on a regular basis (yearly, monthly, etc.) throughout the duration of the contract.
  • Take out one-time costs like setup charges. The TCV should be reduced by any recurring or one-time fees.
  • Choose the Contract Duration: This is how many years the agreement will last in total. A 24-month contract, for instance, would be considered two years if measured in years.
  • If you take the TCV and divide it by the contract’s duration, you get: The ACV may now be calculated. This is the yearly expected revenue for your organization from this contract excluding any one-time payments.

Annual contract value (ACV) formula

It is difficult to make direct comparisons across firms operating in the same industry due to the fact that each SaaS company may opt to compute annual contract value (ACV) in their own unique method. When determining total yearly value, some businesses will factor in one-time payments for setup and expansion as well as attrition rate, while others will not.

The following is a standard formula for determining ACV based on either short- or long-term contracts:

Total Contract Value (TCV) / Total Years of Contract

Let’s examine an illustration. Your business has signed on a new customer for a 5-year deal totaling $30,000 in income.

The Value of One Year’s Contract Work in $30,000

It’s important to remember that expansion income and one-time fees are included in the standard calculation for determining ACV. Currently, you must pay an additional $100 for setup and orientation. Your annual contract value (ACV) will be $6,100 in the first year, $6,000 in the second through fifth years, and $6,000 in the sixth year. Since ARR averages the $100 charge over the full five years, it would provide a different result if calculated.

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Annual contract value vs total contract value

This is when things start to become murky.

Total contract value, or TCV, is a more comprehensive metric that takes into account the length of the contract when calculating revenue. Using our earlier example with Customer A, the TCV would be $60,000 instead of $20,000 since it would cover all three years of the contract rather than just the first.

You should prioritize measuring ACV above TCV if you want to know which clients are your most reliable revenue source. ACV also allows for a fair assessment of the worth of customers with varying contract lengths, such as annual and multi-year commitments.

However, TCV is the correct statistic to employ if you want to know who your most valued clients are throughout the course of the full contract. When determining a discount percentage for repeat clients, TCV is also more relevant than ACV.

Measure your ACV for business growth

Now that you understand ACV and how to maximize its value, it’s time to get out the spreadsheets and get to work. You can better target your marketing and pricing efforts, learn who is most important to your business, and monitor the overall health of your SaaS enterprise if you have a firm grasp on the ACV of your customers.

Not just a meaningless acronym, but rather an additional resource for expanding your SaaS business.

Ombir Sharma is Outreach Specialist at Tecuy Media. He is also an SEO and writer having an experience of more than 3 years in these respective fields. He likes to spend his time researching on various subjects.