In the last years TAM had become one of the most important metric that investors are looking at, before deciding to invest in a new business. This is why every entrepreneur need to now how to how to calculate the total addressable market for an business.
Table of Contents
What is TAM – Total addressable market?
TAM stands for Total Addressable Market. It represents the total market demand for a product or service. Shows how big the market for a specific product or service is.
It is based on a narrow targeting approach that takes into consideration just those specific customers that probably will buy from your business.
Entrepreneurs need to calculate TAM because this metric helps them understand the size of the market in, which they are operating. Based on this metric, TAM, they can assess the business opportunity and decide if to enter a new market, or not. Also, they can make informed decisions like how to allocate resources, what growth strategy to use, etc.
If you are an entrepreneur, it’s important to understand that TAM represents the overall market potential and may not be fully attainable by a single business. The actual market share or the revenue captured by a business is typically much smaller than TAM. This will be influenced by factors such as competition, customer adoption rates, and industry-specific conditions.
Why is important to know how to calculate the total addressable market?
-
Understanding the market size
TAM helps you determine the size and the potential revenue for your business. By calculating TAM, you can estimate the total potential revenue of your business, if we assume you’re your business will capture 100% of the market. This information is crucial for assessing the opportunity of the market and calculating the opportunity cost (investing in other ideas, or industries)
-
Finding investors and obtaining funding
To grow your business, you will need funding. Usually, this funding is obtained from groups of investors, that also see the opportunity in the market. To convince investors that your business has a promising potential, you need to tell them the TAM. This information will help investors assess if you have enough room to grow, for them to multiply the investment that you ask for. “What is your TAM?” is probably the first and most important question that you will receive from your potential investors.
-
Making a Business Plan and building a business strategy
TAM analysis provides a foundation for business planning. Based on this metric, you will decide if:
- The initial investment necessary to start your business has the potential to multiply.
- You will set business goals.
- You will allocate resources for brand, marketing, sales, etc.
- You will establish milestones.
- You will build the growth strategy around it.
How NOT to calculate TAM?
Before talking about how to calculate TAM, let’s talk about common mistakes that you can make. These are the big “No-No” when attempting to find out TAM.
-
TAM is NOT calculated “Top to the button”
Saying stuff like: “The industry is 20 billion, and if you take just 1% of the market, we will have a 20 million annual revenue.” Even if 1% may not sound a lot, when you take that market share from other businesses, the reality will be different. You may encounter costly battles with your competitors, entry barriers, and opposition to change from clients, distributors, or suppliers. It can show you the dimension of the industry you are trying to enter, but a realistic market share estimation is done bottom up.
-
TAM is NOT the size of the problem.
-
TAM is NOT the industry as a whole, but the market for your specific product or service.
For example, the Tennis equipment industry is reaching close to 9 billion annually. If you are producing tennis balls, you can’t say that your TAM is 9 billion annually. You need to find out what is the number of tennis balls sold annually, and then you need to multiply that by the price of your products.
How to calculate the total addressable market?
In theory, there are four approaches to this matter. You can calculate the TAM top-down approach, bottom-up approach, and value theory, and refer to external research.
Even if all of them are used, investors argue that the best way of calculating TAM is Bottom-up. One is the Bottom-up approach. This is the only one that takes into consideration the specific situation of your particular business and is the one that you want to use in a discussion with potential investors.
To properly calculate TAM, research to understand what is your niche.
You need to find out:
- How many people have the need you identify?
- How many you can serve?
- How much they are willing to pay?
To answer this question properly, you need to go back to the How to do a customer segmentation analysis? and How to create a Buyer Persona template? articles and make it clear, one more time, who is your customer.
This approach involves estimating the market size by analyzing individual customer segments and aggregating the data. Using the following steps, you will make a proper estimation:
-
Identify customer segments
Making customer segmentation is essential for all businesses. No matter the product or service that you are trying to bring to the market, your customers will be divided into small customer groups that have slightly different needs or wishes.
If you want to penetrate the market and to have a good adoption of your products/services, you need to understand each segment of your customer and create product attributes that bring the expected benefits to your customers. To learn how to do that, read “How to do Customer Segmentation?”
-
Determine the customer base for each segment
The best way of doing this is by researching and putting together different statistics from public data. Take each customer segment and try to gather specific data.
You may try to find data like:
How many people each segment has?
Is this segment part of a growing trend?
What income do they have?
How do they spend it?
How much do they spend at this moment on satisfying the need that you are trying to address?
Where are the top three geographical locations of your specific segment?
etc.Alternatively, you can enter Google Ads, or Meta Ads, and simulate an ad campaign, by imputing all the data that you know about your customer segment in the targeting of an ad. These platforms will give you a pretty good estimate of the people that are using the internet and match the Buyer Persona that you have made.
Ex. 1:
If you have a B2B product or service, and your clients are new companies that are in the first year of business, and they are searching for a consultant to build their business strategy, you can go to the Eurostat, for Europe, or on Census Bureau for USA. Here you will find out how many companies were created last year for each geographical location. Also, you will find data on how many employees they have.; What was the revenue or profit for last year?; and so on.
Depending on your country, you will find local platforms that will give you more detailed information about each company at a national level.
Ex. 2:
If you have a B2C business model, you have a clear buyer persona, and you plan to reach your client on social media, you can use the platform that you identify as being the main one for reaching your customers, and simulate the creation of an ad. Going through the whole process, you will be asked to give the imputes to target your audience.
Step by step, you will create an ad, based on your buying persona. The social media platform will generate an estimated number of customers based on your target audience. Even if it is not 100% accurate, is it a very good estimation of your future market.
To be more accurate, you can combine the information given by these platforms with additional data taken from the National Institute of Statistics for your country, or from other sources, and create a clear image. But this can be a future step after you will create and test your MVP in the market.
-
Assess average revenue per customer
The ideal way is to do this kind of assessment via A-B testing. Meaning that if you already have an MVP, test the price that your client is willing to pay. You can do this by presenting your product in different forms, accentuating different benefits, and asking for different prices. This approach must be tailored to your customer segments.
If, on the other hand, you don’t have an MVP yet, you will need some alternative ways of doing this.
The first option will be to research how your future clients are satisfying their problems at the moment. Find out how much they pay for a solution at this moment. Further, this can be backed up by a survey, in which you will try to understand what will be the willingness to pay, for a product or service that would better satisfy their needs.
How to find out the right price for your product or service?
When it comes to Pricing Strategy, entrepreneurs who are at the beginning of their journey tend to use Price as a differentiator. This usually is a poor strategy and you probably are leaving money on the table, and crippling the growth potential of your business.
For a correct approach on this matter, visit the “How to make a pricing strategy” article.
To have a correct estimation of your TAM, you need to find the best price. And the best way of doing that is by making a pricing strategy, testing it in the market, and de-risk it.
The following approaches are usually wrong:
- Use the price of your competitor to calculate your TAM.
- Using a “premium” price, without knowing what are the pricing references of your customer, or without doing A – B testing the price for your product.
- Pricing your product or services based just on your cost.
I would recommend you build a pricing strategy, test it via your MVP, learn and adjust, and after that calculate your TAM.
To make a Pricing Strategy, I recommend you use the framework proposed by Utpal Dholakia in his book “How to Price Efficiently?”. Even if there are many approaches to this problem, I found this one to be the one that takes into consideration all the important factors of your product or services and the market conditions. Also, it is clear and easy to monitor and adapt your price strategy in real-time, depending on the market conditions.
I will just summarize the practical approach presented by Utpal Dholakia.
Four pillars should be taken into consideration when you are building a pricing strategy.
- Cost
- Customer Value
- Reference Prices
- Value Proposition
We will approach every one of them in the following steps of this Strategy Framework. I will cover the whole process in “How to build a pricing strategy?”.
Formula for how to calculate the total addressable market?
Multiply the number of customers in each segment by the average revenue per customer. Then sum up the values across all segments.
TAM = Total Number of Customers * Price of your product
Conclusion
Understanding the TAM for your business is a difficult endeavor, but it is essential. With this information you can decide to drop an opportunity if you consider that the market is not big enough. Or you can build a growth strategy that can take your business worldwide.
For sure, when it comes to getting funding for your business, “What is TAM for your business?” will be probably the first and most important question that any investor will ask. Because based on this, if planned correctly, the potential investors will understand if your business can be scalable, and what could be the maximum amount of revenue expected.
Take this step seriously and do all the research you can. If something is not clear, don’t hesitate to contact us, we will try our best to answer your question.
