How to determine your Business' Total Addressable Market?

Do you confidently know the revenue your business is capable of generating? Being ignorant of this fact could be catastrophic to your business.
Jun 24, 2020 • 7 minute read
Gauri Gautam @GauriMelb
Technical Co-pilot
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Do you really know the revenue opportunity for your business?

Total Addressable Market, or TAM, is best understood as a reference term for the revenue opportunity that is available for a particular product or service. It is not about the number of customers you can attract, but the amount of revenue that you can generate. In theory, this can be 100% market share as well, however, there is hardly a product or a service without a competitor.

Determining TAM for your business

First and foremost, knowing your business’s total addressable market can help you assess the profit potential of that industry. This is beneficial while launching a new product as you can put together a more effective go-to-market strategy. Further, you can define a more realistic revenue target for your business. 

By placing business figures as close to reality as possible prevents you from entering a market that may not be the right size for your product. So, read on to find out how to determine your businesses’ total addressable market.

Calculating the total addressable market for your business

You must accurately gather certain information before initiating a TAM calculation for your business. This includes a well-defined market segment and profile of the end-user you intend to target with your product or service. Other than this, you must have a very clear understanding of what your ‘ideal customer profile’ is. The reality of these inputs is directly related to the accuracy of the resulting calculations. Some essential inputs include:

  • Identifying the industries is your business likely to generate revenues from or sell into?

  • Characteristics of potential as well as current clients

  • Location of potential clients

  • Size of the companies or clients interested in buying your products and solutions

  • Market growth trends

  • New entrant trends in your market segment

TAM calculation methods

TAM is calculated using basic multiplication principals in which Average Revenue per User or ARPU is multiplied by the number of potential users. Therefore, the formula is,

TAM = ARPU * potential customers in your target market

Typically, the total addressable market is calculated using a top-down approach, a bottom-up analysis, or a Value-theory approach. 

Top-down analysis

As the name suggests, a top-down analysis begins with the total number of people globally and then narrows this number down to the target market based on factors like demographics, geographical location, etc. It is an inverted pyramid method of arriving at the number of target market users that is steeped in assumptions. 

Further, the calculation also relies heavily on data obtained from third-party or secondary sources that may not carry the same definition of a particular data set. Normally consulting groups and secondary market research companies are used for data regarding the number of target users and that meet your product or service market criteria and to know the overall size of the industry.

Limitations 

Here, the research has been done making this an easy and fast approach to arrive at estimates. However, there is always a possibility that the research data may not meet your exact requirements leading to a certain amount of uncertainty. Hence, you may miss out on disruptive products that have the potential of becoming a game-changer.

Solution

Businesses often hire independent or third-party consultants to size-up the market and arrive at a more tailored view. At best, this is a generic approach for calculating TAM and does not always cover specific values and market changes. 

Bottom-up analysis

In the exact opposite manner to the top-down approach, the bottom-up analysis begins with a very small-scale target market and then scales it up to arrive at a blown-out number. In this method, the first set of data usually includes just a small sample of potential customers in theory. This data is then extrapolated and projected over an industry, market, country, etc. In other words, the bottom-up analysis utilized data derived from early selling efforts. 

The basic data set is certainly more accurate as it is based on more than just theory. For instance, in most cases, the basic data comes from a limited pilot test. This method is seen as more reliable as it is based on data that gets generated in-house rather than third-party statistics. 

Limitations

Bottom-up analysis can be highly time-consuming. This makes it unsuitable for those businesses that are on a tight product launch schedule. However, for this method to work, the data should not just be reliable but also provide a realistic estimate of the target user numbers to meet the business’ target addressable market criteria.

Solution

One cannot possibly ignore the benefits of accurate estimates in this method that are closer to home than any other approach. Therefore, the best way to overcome the time constraints is by initiating the process early on in the product conceptualization stage. 

Value-theory approach

While the above 2 are the most commonly used TAM calculation methods, the Value-theory approach has its own unique applications. This total addressable market calculation method is recommended when the business is looking at creating an entirely new product category without an existing market analysis or data to use as a base for calculation. Further, a service or a product that can evolve and transform a market or provide value-added services to customers. In other words, value-theory uses conjecture in order to determine the buyer’s willingness to pay.

This approach begins by raising very basic questions like, what a potential buyer will be willing to spend to obtain the value that the product or service provides. This potential product value is multiplied by the target market numbers to arrive at the total addressable market figures.

Limitations

The value-theory is not applicable in all scenarios and is, therefore, not a very widely used form of TAM calculation. Even where it is applicable, this approach must be used with as much realistic data for estimation as possible as the business is entering into an entirely new market without any precedents. 

Solution

Both, bottom-up and top-down analysis cover the products and services that cannot use this value-theory for TAM estimations. 

Out of these three calculation methods, the bottom-up analysis method is most likely to project results that are closest to reality while the value-theory calculation method is more of a ‘wild-card’ approach to avoid entering band-new markets without prior data.

TAM calculation

After you have arrived at the total addressable market using one of these methods, you can now determine if it is worth it for your new business venture or not. According to experts, the ideal market size of the industry should range between $20 million and $100 million per year for a business to enter the segment. 

A market size lower than $5 million per year is not worth entering as it may be too niche, or it may become excruciatingly difficult to convince your investors on the market’s revenue generation potential. 

On the other hand, a market size that is 1$ billion per year is also not considered worth entering. This is because such a market may be highly saturated making little sense for you to enter. 

Therefore, it is not only important to run an accurate number for your market segment, but you must also validate that market properly. 

Understanding the difference between TAM, SOM, and SAM

All the 3 terms represent different subsets of the target market. While TAM stands for Total Addressable Market, SOM means Serviceable Obtainable Market, and SAM is an acronym for Serviceable Available Market.

TAM defines the total demand in the market for a product as translated in annual revenue generation potential and SAM is what gets addressed by the business’s services or products. Lastly, SOM tells what percentage of SAM is achieved realistically. It is not easy to identify all of these subsets within the industry without substantial market research to analyze and assess the proportion of each of the different areas. 

Why must you be aware of your business’ total addressable market?

  • The biggest advantage of TAM is that it allows businesses to accurately visualize the market for their services and goods. 

  • As a business owner, you can think more strategically about how you can expand your current market share with your existing capabilities and resources and in the presence of your competitors.

  • You are not entering new markets blindly. With TAM you are more aware of the revenue generation potential of the total addressable market.

  • It allows businesses to assess their comparative as well as absolute advantages in the market and help them carve out new paths. 

  • You can create more focused and relevant future roadmaps for your business.

  • Possessing accurate information provides a sense of security for investors as well. This can help you attract as well as retain potential investors.

  • As a business owner, you can stay ahead in the market by identifying your competitors early on. TAM calculations also force businesses to define themselves and see where they are placed in the larger competitive landscape.

  • It helps you minimize any potential hurdles in the launch of a new product or service.

  • Accurate TAM calculations are beneficial for ensuring that the new product or service is profitable.

Final thoughts

Irrespective of whether your investment in a business venture is large or small, you always hope for successful profit generation. TAM forms an essential ingredient towards ensuring that you meet your goals by giving you an accurate estimate of your potential client base, the revenue that you can generate, and ultimately the growth you can achieve. It is always good to know how many eggs are in your basket so that you can prepare for the number of chickens that will hatch.

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