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Total Addressable Market: How to calculate TAM?

  • Bhumika Dutta
  • May 19, 2022
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If we talk about all the startups and small businesses, any firm around the globe, regardless of its revenue, has a lot of space for expansion. Before diving deeply into the competition, one must properly examine every industry's profit potential. 


It is also critical for the aforementioned corporation to forecast a reasonable revenue growth target for the organization. To do so, they must first determine the total addressable market.


So, what is the total addressable market? This will be the subject of this article's discussion.


What is the Total Addressable Market?


The Total Addressable Market (TAM), also known as the total available market, is the total revenue opportunity that a product or service has if it achieves 100 percent market share. It aids in determining how much time and money a person or corporation should devote to a new business venture.


It's the maximum amount of money a company may make by selling its product or service in a certain market.


The idea of a total addressable market is significant for startups and established organizations because it allows them to select certain products, client groups, and business possibilities based on estimations of effort and capital necessary. TAM may be used by corporate management to give a plausible value proposition to potential investors and purchasers of the firm.


Most businesses can't capture the complete addressable market for their product or service unless they have a monopoly. Even if a corporation just has one competition, convincing an entire market to buy solely their product or service would be incredibly tough. 


That's why most businesses calculate their viable potential market to see how many clients they can reach using their marketing and sales channels. They also calculate their market share to determine the size of their real target market. Total addressable market, on the other hand, is still relevant since firms may use it to objectively evaluate a market's growth potential.


Ways to calculate Total Addressable Market (TAM):


TAM is calculated using a simple multiplication problem: average revenue per user (ARPU) multiplied by the total number of prospective consumers in the target market


The first component of the equation is simple and can be altered as part of the business planning process, while the second portion is more difficult.


TAM = (ARPU * Total potential customers in the market)


External data sources, such as industry analysts or government figures, are frequently utilized to assess total prospective clients. However, those sources seldom break down the market in the same way that a specific firm does. 


While these figures can serve as a starting point, further work is required to arrive at a figure that more truly indicates the number of probable clients.


Here are three approaches to how you can calculate the total addressable market value:


  1. Top-Down Analysis:


The top-down analysis uses an elimination procedure that begins with a big population of known size that makes up the target market and narrows it down to a single market segment. 


An inverted pyramid depicting top-down analysis depicts a big population of a known section at the top and a narrowed-down segment at the bottom. The population estimates are obtained using industry research and reports.


A start-up technology company, for example, has developed an app for small businesses that cannot afford premium accounting software. According to industry studies, there are one billion firms in the globe, with 30 percent of them lacking access to premium accounting software (30 percent x one billion consumers = 300,000,000 prospective clients). According to research, 90% of organizations that do not utilize a premium accounting tool use a full-time in-house accountant. This raises the total number of prospective firms to 10% of 300,000,000, which equals 30,000,000. If the company provides the software for free but charges $100 per year for subscriptions, the total addressable market is projected to be $3 billion (30,000,000 x 100).


Advantage: Top-down relies on third-party organizations for macroeconomic data. This sort of information already exists and is easily accessible through several websites and institutions.


Disadvantage: The data may not be completely correct because it originates from other sources. The top-down approach also ignores disruptive innovations that transform or establish entirely new markets as a result of their success.


Also Read | Everything about Product Market Fit (PMF)


  1. Bottom-Up Analysis:


Because the TAM estimations are produced through primary market research, bottom-up analysis is a more trustworthy strategy. It takes advantage of more trustworthy data about a product's current pricing and consumption. 


The benefit of a bottom-up strategy is that the organization can explain why some consumer groups were chosen and others were not. The addressable market would be more relevant and accurate if the firm relied on data from its study or survey rather than depending on inconclusive data.


For example, a new firm with a free accounting mobile app and $100 yearly memberships can calculate the TAM by making a realistic estimate of the number of enterprises in its target market.


Advantage: The final estimate for bottom-up TAM is more likely to be accurate and relevant to your firm because it is based on your data gathered in-house.


Disadvantage: The ultimate TAM computation produced from the bottom-up method might be deceptive since assumptions are made based on a restricted group of data. This is especially important if you're trying to calculate a worldwide TAM, as factors like population density, economic development, and consumer behaviors can differ significantly from nation to country.


  1. Value Theory:


The value theory is based on a calculation of the product's worth to customers and how much of that value may be represented in its pricing. A business determines how much value it can contribute and why this value should be captured through product price. When a corporation introduces new items to the market or cross-sells particular products to current consumers, value theory is used to determine TAM.


Uber's addressable value may be estimated using the value theory technique. Users who use Uber cabs have the choice of driving themselves, utilizing public transportation or taking taxis from competitors. Because consumers are prepared to forsake all of these options in favor of an Uber taxi, the firm can assess the value that these users gain from using Uber cabs and figure out how to capture that value in its price.


Advantage: Companies that have produced a unique product that is developing new markets or changing existing ones might benefit from value theory. It's an effective strategy for businesses that don't have access to market data or the capacity to perform their study.


Disadvantage: Value theory is mostly dependent on speculation and assumption, and its results will never be entirely true. You can estimate how to capture that value through price by concentrating on the value your product can bring to consumers.


  1. Third-Party Research:


Third-party consultants are frequently employed to size a market to gain a more personalized picture. They can do email or phone polls, examine other data, and make more educated assumptions, but at a considerably greater expense. Using already done research is the simplest and fastest option, and it's acceptable for high-level projections, but it's seldom actionable and carries a lot of uncertainty.

At the end of the day, you may only have a revenue amount and/or a list of organizations unless the insights are actionable. Frequently, the method for operationalizing that understanding is still lacking. This method of calculating TAM is broad and lacks particular instances of value or market shift.

The TAM depicts the notional complete market for a product, assuming unrestricted access to it and the provider's limitless operating resources. This would only be achievable in a monopolistic business, where one operator had the resources and size to serve the whole potential market. In general, only government services and public utilities are eligible for this incentive.


Why is it that, since it's very hard to collect 100% of a TAM, it's included in practically every pitch deck? A TAM will spit out a huge number, which will draw attention and generate discourse. However, the devil will be in the details of the TAM's second and third layers: the Serviceable Available Market (SAM) and the Serviceable Obtainable Market (SOM).


The difference between TAM, SAM, and SOM:


In the previous paragraph, you have been introduced to two new terms: Serviceable Available Market (SAM) and Serviceable Obtainable Market (SOM). 


The TAM  for a product or service is calculated in terms of yearly revenue. The target addressable market that a company's products or services serve is known as the SAM.  SOM, on the other hand, stands for Serviceable Obtainable Market, or the proportion of SAM that can be reached realistically. To determine the proportions of each category, considerable market research is required to identify various subcategories within an industry.


Looking at an example of consumer expenditure on food in the UK. This market was predicted to be worth 200 billion euros in 2014, which represents the entire addressable market. Fresh food, as well as alcoholic and non-alcoholic beverages, are sold in the consumer food industry. The serviceable available market is the alcoholic beverages business, which serviced 49 billion euros. The sector is serviced by several big manufacturers and suppliers. The serviceable obtainable market is a segment of the alcoholic beverages industry that is supplied by a single producer.


Importance of Total Addressable Market (TAM):


When considering any company opportunity, the Total Addressable Market is the initial element in virtually every business case and the most important information to examine. It can be difficult to confirm any following predictions about income, growth, or usage without a notion of how many individuals or corporations could purchase a product. Here's why it's so critical:


  1. When a company contemplates developing a new product, entering a new vertical market, or even introducing a new feature, it's vital to know how that strategic decision will affect revenue. TAM calculation may suggest that an opportunity isn't as appealing as first anticipated, or it may disclose a larger market than previously thought. 


Companies may make better-educated judgments about where to invest their time and money for optimum ROI using this information, including abandoning plans if the TAM is too low.


  1. TAM is also useful for estimating the impact of a new market entry or a pricing adjustment. Understanding how market share may change as a result of these factors is only truly meaningful when the complete market potential is grasped, as it extends the implications of these activities to revenue predictions.


  1. TAM is one of the most crucial data elements when investors or board members are analyzing a company's or product's possibilities since it offers a relative value for the opportunity size compared to other investment alternatives they may be considering. The TAM calculation procedure also requires a firm or product to identify itself and determine its place in the competitive environment.


  1. While TAM may be estimated for a certain point in time, it is subject to change. Markets shrink and increase all the time as a result of demographic shifts, business cycles, and technological adoption; therefore, when utilized as a part of a prediction, those macroeconomic factors should be taken into account, and estimates should be reassessed regularly.


Advantages of knowing the Total Addressable Market:


Here are some advantages of knowing the total addressable market:


  1. The TAM aids in the development of a solid grasp of the future returns that an investment may provide.

  2. Calculating the total addressable market reveals the reality of a new enterprise and aids in determining its viability. You may find that the present market offers fewer opportunities for success than you anticipated or were encouraged to think. This will keep you from wasting money on a pointless venture with a low chance of a large return on investment.

  3. Calculating a product's or service's total addressable market might indicate that its potential is significantly bigger than previously thought. To make the most of it, further funds or resources may be necessary. As a result, information on the entire addressable market might assist in obtaining financing from investors.


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