Learn how to calculate ACV and find the best sales strategy for your business!
Annual contract value (ACV) is a key metric used by sales teams to show how much an ongoing customer contract is worth by breaking down its value annually. ACV calculations are typically based on the recurring revenue generated by a single client or account.
Recurring revenue is the income from customer purchases repeated over a period of time. It can come from membership fees, subscription costs, or other forms of repeating customer payments.
ACV calculations don’t usually include one-time setup fees, training costs, and other administrative costs charged to the customer; most companies omit these initial charges. Here’s the formula for calculating ACV:
The ACV formula averages the annual revenue generated from each customer contract that a business has. For example, if a customer signs a five-year contract for $100,000, then the average of this value per year will produce an ACV of $20,000 ($100,000 / 5).
Note that ACV isn’t an industry-standard metric; some businesses may include one-time fees and other customer costs in their ACV calculations. Regardless of how you set up your ACV formula, make sure to standardize it across your organization so you can compare metrics accurately.
You may be wondering why your business must calculate ACV. ACV calculation can offer key sales insights that can influence your decision-making. To make the most of these insights, use them to determine your business’s sales strategy. (More information on this in the next section.)
Since ACV normalizes your contract amount—i.e., removes any nonrecurring expense or income from l calculations— it can be used to:
- Determine which accounts provide the highest revenue
- Improve service for customers who have the greatest long-term revenue potential
- Compare contracts to check which is bringing the highest potential revenue
A business can be successful with a low or high ACV. Neither strategy can be deemed “good” or “bad”; they are simply two different approaches. It’s up to your sales team to decide which strategy makes the most sense for your business.
- Low ACV sales strategy: Businesses with low ACVs usually focus on gaining more customers at low subscription costs. For instance, most music streaming services use this strategy. The subscription cost of a music streaming platform is usually quite low, which attracts many users to download the app. This sales strategy doesn’t require much work to acquire new customers.
- High ACV sales strategy: Organizations with high ACVs usually spend more money on customer acquisition than companies with low ACVs. For instance, businesses that sell software platforms have much larger ACVs, as their subscription costs are quite high. Such companies may not have many customers, but that is balanced by the high value per customer contract.
ACV is a vital business metric for software-as-a-service (SaaS) companies, as these businesses primarily offer annual or multiyear subscription plans.
SaaS businesses are companies that host software applications made available to customers via the internet. In a SaaS setup, the software app is hosted on the vendorʻs server, and customers can access it from any remote location via the internet. SaaS customers pay a subscription fee—billed monthly or annually—to access the application.
Examples of common SaaS applications for small businesses include:
- Customer resource management (CRM) software
- Enterprise resource planning (ERP) software
- Human resources software
- Accounting software
- Billing and invoicing software
- eCommerce software
- Project management software
- Data management software
SaaS metrics are defined as benchmarks that companies measure to establish steady growth. SaaS businesses typically compare ACV with other business metrics to inform sales, marketing, and pricing strategies. SaaS metrics that are compared with ACV include:
- Annual recurring revenue (ARR): ARR indicates the revenue a company’s total customers generate over the course of a year. Use ACV to normalize customer accounts annually and provide an accurate ARR calculation. (This topic is discussed further in the next section.)
- Customer lifetime value (CLV): CLV refers to the projected total revenue generated by a customer over the lifetime of their account. Use this sales metric along with ACV to predict how profitable a customer account will be in the long term.
- Customer acquisition cost (CAC): CAC calculates the cost of acquiring a customer in a subscription business. Compare ACV with CAC to determine how long it will take to gain back the money spent to acquire a customer. This is quite useful information to possess, as it can be used to inform product pricing and marketing strategies.
When calculating ACV, be sure not to confuse it with ARR. ACV is the amount a single customer account is worth over a one-year period, whereas ARR is the sum of all subscription revenue (multiple customer accounts) expressed as an annual value.
ARR insights can be used to:
- Track growth in revenue over time
- Pinpoint income fluctuations from subscription upsells, renewals, or cancellations
- Forecast company revenue using fluctuation insights