Remaining performance obligation (RPO) in SaaS

SaaS companies use different customer acquisition models, pricing models and billing frequencies. The complexities of usage-based pricing and hybrid/multi-engine customer acquisition models make revenue forecasts and revenue metric calculations a lot harder.



RPO presents investors with a better picture of a company’s prospects regardless of its pricing and business model.

While not required, some public SaaS companies also include billings in addition to RPO in their statements to provide more visibility into future revenue. However, we’re likely to see billings reported less frequently in the future. This is because in addition to adding more clarity to the revenue picture, RPO also provides a leading indicator of growth as it illustrates a company’s momentum in revenue growth. Thus, RPO provides a more accurate measure of a company’s prospects for investors

Accounts for more business models

“For instance, a company that switches from annual to half-yearly invoicing will experience reduced deferred revenue numbers and an increase in backlog.
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RPO captures both deferred revenue and backlog while billings captures just deferred revenue. As a result, RPO offers a true picture of future revenue and is unaffected by subscription term changes.”_{Kirk Kappelhoff, Director of Strategic Finance, Drivetrain}

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SaaS companies use different pricing models and billing frequencies during the normal course of business. RPO presents investors with a better picture of a company’s prospects regardless of its pricing and business model.

Billings uses changes in deferred revenue, not backlog, when reconciling back to revenue. In addition, a change in subscription frequency affects deferred revenue numbers, leading to an inaccurate picture of billings.

Businesses interpret and apply ASC 606 in different ways for RPO

ASC 606 gives businesses quite a bit of latitude in how they interpret and apply the code in their reporting of revenue. However, ASC 606-10-50-17 requires that they explain their methods and rationale for revenue recognition from contracts, including how they define performance obligations and RPO:

An entity shall disclose the judgments, and changes in the judgments, made in applying the guidance in this Topic that significantly affect the determination of the amount and timing of revenue from contracts with customers. In particular, an entity shall explain the judgments, and changes in the judgments, used in determining both of the following:

• Total revenue of $1.80 billion
• Deferred revenue of $0.88 billion

By looking at the Security and Exchange Commission (SEC) filings of publicly traded SaaS companies, we can get a better idea of how much the definition of RPO varies:

How to calculate RPO

RPO is calculated by adding your business’ deferred revenue to its backlog as shown in the following formula:

Deferred revenue represents the revenue that has been invoiced to a customer for the period but the product or service has not yet been rendered.

Deferred revenue, also known as unearned revenue, exists as a liability on the balance sheet because it depicts money that is invoiced when an obligation has been fulfilled. Deferred revenue will be reflected on the income statement when the obligation has been fulfilled.

Backlog represents the revenue that is contracted but has not been invoiced.

For example, a sales representative gets a customer to sign a two-year contract for $10,000 per year, which is prepaid on an annual basis:

• The total contract value (TCV) is $20,000.
• The deferred revenue is $10,000 which is invoiced at the beginning of the first year and is expected to be paid by the customer up front.
• The backlog is also $10,000, which is for the second year of the contract, which won’t be invoiced or paid until the beginning of the second year.

Note that the term “backlog” in the context of RPO is not the same as the “backlog” SaaS companies talk about when discussing their sales pipeline.

An example of an RPO calculation

Let’s look at an example calculation of RPO for an enterprise SaaS company, which has:

• An average contract duration of three years.
• An average annual contract value (ACV) of $144,000 ($12,000 per month).
• Implementation and service fees of $2,000 per month paid monthly for six months ($12,000 total).

Our company has just closed on a three-year contract that requires a six-month upfront payment of the subscription fees.

So, to calculate the RPO under this contract, we need to determine how much we have in deferred revenue and how much we have in backlog.

It’s important to note here that RPO is a point-in-time metric, meaning it is a snapshot of your data at a particular point in time. Because you’re continually providing services under a contract, your RPO is dynamic, and changes as you provide those services (i.e. fulfill your performance obligation) over time.

Deferred Revenue

At the beginning of the contract, in its accounting system, the company debits the accounts receivable (AR) and credits deferred revenue (payment for services not yet received). In our example, this would be $74,000, which is subscription billings of $72,000 plus the first month’s service fee billings of $2,000.

Backlog

In order to calculate the revenue backlog, we first need to know the total bookings for this contract. The formula for calculating the bookings is shown below:

In our example, the total booking would be calculated as follows:

Recall that backlog represents the revenue that is contracted but has not been invoiced. So, in this example, at the beginning of the contract, the backlog is the sum of the full three years, minus the amounts billed upfront (the deferred revenue).

The table below shows how the two variables in the RPO equation, deferred revenue and backlog change over time:

You’ll notice that as time goes on and you continue providing services under the contract, your backlog continues to go down. Your deferred revenue also decreases because, as the figure below illustrates, with every month you provide services, you’re “chipping away” at it when the revenue for that month is recognized.

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So, going back to our table, you see that when you get to the beginning of Year 3, no backlog will remain. And at the end of Year 3 when you have provided that last 12 months’ of services, no deferred revenue will remain either. All revenue from the contract will be recognized.

Now that you can see the relationship between deferred revenue and backlog, let’s assume that we just signed the contract and want to report the RPO for the first year of economic activity under this contract. At this point, we haven’t provided any services yet.

This calculation includes one customer and one contract, and SaaS companies normally have multiple customers and multiple contracts. Finance teams can calculate RPO per contract, however RPO is normally totaled for all customers and contracts and reported each financial quarter.

Should you use RPO or billings?

The RPO metric plugs a few holes that billings does not account for. SaaS companies typically report billings to offer investors a view of expected future revenue. However, billings poses an accounting challenge for investors.

This is because a company that lists billings as a key metric in its annual report filed with the SEC (called the 10-K) must reconcile this number to revenue, which is done by calculating the change in deferred revenue.

Here’s an example of a reconciliation:

While this reconciliation is straightforward from an accounting perspective, investors find it cumbersome due to the reasons we previously described when discussing why investors find it easier to interpret RPO.

Briefly, the reconciliation involves deferred revenue which poses its own challenges to investors. RPO removes any need for a reconciliation because it captures future revenue with a straightforward, easy-to-calculate formula.

Using billings as a key metric creates bigger issues for SaaS companies because it can lead to an unfair devaluation. The problem is its opaqueness. Consider the following example:

SaaS company A records the following subscriptions:

• $100 for a one year contract paid upfront.
• $200 for a two year contract paid upfront annually.

From an ARR perspective, both contracts generate $100. However, deferred revenues on the financial statement will show $200. This can be broken down as:

• $100 for the one year contract
• $100 for the first year of the two year contract

Simplify revenue analysis with Drivetrain

RPO offers SaaS companies a comprehensive view of revenue and a company’s financial health. SaaS companies need to keep an eye on RPO because it’s a useful metric for investors.

Drivetrain simplifies revenue analysis for SaaS companies, especially SaaS companies with different business models or invoicing cycles.

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Drivetrain is also a powerful revenue forecasting tool, which can help companies gain full visibility into their sales pipelines in real time to understand their pipeline coverage ratio and sales velocity. For example, Lambdatest was able to “tame” a highly complex sales operation that included multiple sales channels with several teams operating in each. With Drivetrain, Lambdatest was able to scale faster, streamlining its sales forecasting with full visibility into dozens of funnels and the ability to evaluate each against multiple metrics in real time.

You can scale faster with Drivetrain, too:

• Consolidate all your financial and business data in one place—store all your MIS data in one place, creating a single source of truth for financial and operational data.
• Speed up analysis—you can create visualization dashboards that are easy to understand, which will speed up analysis. Collaborate easily by sharing them with investors and stakeholders. With one-click root cause analysis and powerful what-if analysis, identify growth bottlenecks and get back on track quickly.
• Build custom reports—you can create reports for your internal team and reports to show your investors. Increase visibility into your business by breaking down data silos and tracking important metrics such as ARR, churn rate, NRR, and RPO.