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Total Addressable Market And Its Importance for Businesses

  • Jul 09, 2021
  • Posted By: Robert Duke
  • Category: Articles
Total Addressable Market

When you start a business, several worries haunt you every step of the way. One of the biggest worries is – how many people might be interested in our product? By having an idea about the total market for your product, you can gauge how much growth potential is there for your new business or product and understand the size of the current marketplace.

Whether you are just setting up your business or past the startup phase, the Total Addressable Market metric can help you make validated predictions about growth and revenue. If you are new to this concept or want to gain in-depth knowledge on the topic, the below guide has all the information that you can use to figure out your Total Addressable Market to drive your business growth.

Total Addressable Market

Source: therevopsguy

What is the Total Addressable Market (TAM)? 

With the help of the total addressable or achievable market, you can gain an understanding of the overall revenue potential for your product or service. You can predict the total demand for your product or service across:

  • All segments.
  • All possible alternatives or substitutes.
  • And via all potential channels, i.e., the total demand available to a business if they were the only supplier of a product or service.

Consider this example to understand better: If you are a supplier of metal screws selling through online channels. When calculating the total addressable market, you would include all types of fixings (screws, nails, adhesives, etc.) available through all channels – online or offline, via distributors, or direct from manufacturers.

Why it is Important to Understand Total Addressable Market?

When you start your business with a new idea, the excitement can lead to impulsive decisions, which can be expensive down the line if there is no real market to build on. No entrepreneur or investor should leap without understanding all the risks and opportunities of their new venture. With the help of TAM, they can gain a concrete understanding of the potential gains their investment may accrue in the future.

They can not just get an idea of the reality of their new venture but also determine its validity. Below are some reasons why this metric is so important.

  • It helps you build your long term vision
  • It helps you understand your market size
  • Attract investors by showing conviction and accuracy.
  • It helps you focus on the future roadmap and product evolution.
  • It helps you assess your product-market fit.
  • Puts competitors within a line of sight from the start.

Important Questions Businesses Need To Answer For Calculating TAM

Getting an accurate view of your total achievable market size requires you to answer some important questions.

1. What is my addressable group?

Knowing your target market and the behavior patterns of your potential consumers is one of the most important aspects of planning a business. Understanding your consumer makes it easier to:

  • Reach them with targeted advertising and outreach.
  • Estimate your target market size, which enables you to make more accurate financial estimates.

The addressable market or group is the part of the total market that can be targeted with your product. For example, the US software market is in the billions of dollars per year. But if you made software for working mothers, then your addressable market is some portion of all women. The deeper you understand who behaves and spends in what particular way, the better you will be able to know your target market.

2. What industries can you sell to?

If you have a B2B product, then it’s important to account for all the industries your product may be of interest to. You may have developed your product with one industry in mind, but it may have a broader appeal.

3. What is the current competitive landscape?

The total addressable market assumes you have no competitors, so it isn’t a direct part of the calculations. But getting an idea of the current competitive landscape is important for two reasons:

  • It helps you gather data for the calculations if needed.
  • You can get a better understanding of ways to interpret the TAM.

4. What are the customer profiles?

Besides knowing the market size, market research involves knowing what types of people will be purchasing your product or service, the amount they are willing to pay for it, and factors affecting their buying decisions. To calculate TAM, knowing what value your target customers place on your product and services can be crucial, depending on the calculation method you choose.

5. What does market growth look like?

Market growth refers to the rise in demand for a product or service. It’s important to assess your market’s growth potential by studying trends, like – year-to-year industry-wide sales and the size of purchases per customer, etc., to get some idea of where your total addressable market will be heading, the number of customers, and type

Ways To Calculate TAM

It can be difficult to calculate the total addressable market, especially if several competitors in the space are opaque about sales figures. There are three approaches you can adopt for calculating TAM:

  1. Top-down
  2. Bottom-up
  3. Value theory

Top-down Approach

These calculations are often based on existing work by market-research firms, such as Forrester and Gartner. However, these studies must be supplemented by extra assessments, email, or phone surveys to draw specific conclusions about particular markets.

In this approach, you start with the largest possible size estimate and reduce it using information and assumptions about your market and business.

For example, if you want to launch a business that delivers tomatoes on demand, you will consider the market size for Tomatoes. Then consider how much consumers spend on food today. Of all those customers, not everyone who buys fruits and vegetables will want them on-demand. Only a small percentage of those consumers, let’s say 20% that live in large cities, may want tomatoes on demand. So, you will assume only 20% of those sales can be served by your business. You may consider other factors too like how many customers buy from supermarkets etc.

Using this strategy has various pitfalls –

  • The surveys may not be reliable when they are based on self-reported data and not entirely transparent company info.
  • It ignores the fact that the introduction of some products can change the TAM.

Bottom-up Approach

This number is calculated by beginning with a small calculation and applying it to the larger customer base of your target market. In this approach, either a small base of theoretical buyers is analyzed, or real research is used before applying it to a much bigger customer base..

The target market is figured out by researching the type of customers you think will buy your products.

For example, suppose you sell a B2B software solution for small-sized firms. In that case, you can calculate the number of those firms in the appropriate sector, the average number of employees they might have, and the number of those who are most likely to use your software.

Below is the formula to calculate TAM by this method.

TAM = (Annual Contract Value) x (no. of possible Accounts)

TAM figure you finally come up with using this method is built on a solid sense of who exactly makes up that market.

Value Theory TAM Analysis

This method relies much more on supposition and guesswork, so its conclusions are often not very clear but still useful. It works the best for innovative products, new features, and upgrades with no existing examples to compare them to.

To calculate TAM using this method, estimate the value that your product provides to certain users and then identify how much the buyer would be willing to pay for it.

In this approach of TAM calculation, you also need to estimate how many customers may find value in your product and choose it over alternatives.

Final Words

The Total Addressable Market may be calculated for a snapshot in time, but it changes based on the market conditions. Markets expand and shrink all the time based on business cycles, demographic changes, and new technology introduction. So when used as a prediction method, the macroeconomic elements should also be considered, and calculations should be revisited regularly.

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