The first step to business success: Calculating your TAM

 

Every successful business begins with an idea that promises something new or improved. But before you dive in, you first need to survey the landscape to gauge the number of potential customers who may be interested in what you have to offer. That’s where your total addressable market comes in. Think of it as sizing up the pond before you cast your rod. Without it, you’re just fishing in the dark.

 

What is total addressable market?

Total addressable market, known as TAM or sometimes referred to as the total available market, is the full revenue potential your product could achieve if you captured 100% of the market. In simpler terms, it’s the amount of money your business could make in a perfect world with no competition. Understanding your business’s TAM can help you assess the size of your market, estimate your business’s growth potential and plan for success.

 

Why calculate your TAM?

TAM provides a best-case scenario that can help you make crucial decisions to support your future. Calculating your TAM is an essential step in shaping your business model and a key component of a comprehensive business plan. Understanding this number can help you:

• Identify business potential and revenue opportunities to measure the likelihood of your product or service succeeding in the market
• Prioritize business opportunities or goals with the highest potential for growth 
• Pinpoint the resources and funding you need to win the market
• Scope the competition early on to hone your differentiators

 

How to calculate TAM

Calculating TAM calls for simple multiplication:

Average revenue per customer × Total number of potential customers in your target market

There are three common ways to source the data you need to make your TAM calculation, each with its own advantages and drawbacks.

 

Top-down

In a top-down approach, you use existing market research, such as industry reports, and then tailor the data to your specific market. Start with a broad population. Then apply demographic, geographic and economic assumptions to chip away at the data until you reach the subset that most directly represents your business case. The exact equation will vary based on which data you can track down, however most follow the basic formula:

TAM = Average annual spending per person × Number of residents

By taking additional factors into account — such as percentages of the population likely interested in your product, or existing competitors — we can further narrow in on the exact market.

Consider a budding coffee shop owner looking to open a new location. In this case, the owner starts by looking at the overall market size for coffee shops in the United States and finds it’s worth $45 billion. To narrow down this market size to the portion relevant to their business, they focus on the coffee shop market in their city. Say they estimate there are 200,000 coffee drinkers in their city, and 40% of them visit coffee shops at least once a week. After surveying prices at various coffee shops throughout the city, our owner finds that the average price is $5 per cup. Let’s assume they will plan to capture a 10% share of the market.

With all of the basic pieces in place, our owner can combine this information to calculate their TAM, amending the original equation like so:

TAM = Total market size x Target population x Average purchase frequency x Average price x Market share
TAM = $45 billion x 200,000 coffee drinkers x 0.40 x $5 per cup x 0.10 = $18 million

Remember, this figure doesn’t account for existing competitors, but rather provides a high-level estimate of the potential market size for your product or service. The upside of this approach is that most data on this scale is widely available — from market research firms, government agencies, financial news outlets, academic research or annual reports by publicly traded companies. It’s also the least time-consuming of the three. The drawback of this method is that it may also be the least accurate. The data set may be outdated and likely won’t reflect the niche factors of your market or how your business could influence them moving forward.

 

Bottom-up

A bottom-up approach relies on your business’s current pricing and sales data. Because the calculation is based on your existing data, it can be more accurate and allows for a deeper dive into the market.

For our coffee shop owner, this process could involve recording their shop’s sales data over the course of a year. With this data, they can determine their annual revenue per customer (also known as annual contract value, or ACV) by multiplying their average sales price by their total number of current customers. Say the coffee shop’s average customer spends $5 per visit. On average, a customer visits the coffee shop three times a week and the shop operates year-round.

ACV = (Average sales price per visit x Frequency of visits per week) x Number of weeks in a year
ACV = ($5 per visit x 3 visits per week) x 52 weeks in a year = $780 per customer per year

To calculate the TAM and gauge the business’s potential, the next step is to multiply the average revenue per customer by the total number of potential customers. If the coffee shop identifies 20,000 potential customers in their local area, the TAM can be calculated as:

TAM = ACV × Total number of potential customers
TAM = $780 x 20,000 = $15.6 million

This shows us the potential revenue our coffee shop could bring in if they captured 100% of the market. While the bottom-up approach may be more time-consuming than the top-down method, because it is based on the owner’s existing data, the accuracy it delivers can be a great asset when weighing new business ventures.

 

Value theory

The value-theory approach estimates how much value your product or service brings and then compares it with the price. This method is particularly helpful when evaluating the viability of your business model.

Back to our coffee shop owner. Only this time, let’s consider that our coffee aficionado wants to offer highly artisanal, sustainably sourced, fair-trade coffee blends. To calculate the value-theory TAM for this coffee shop, first we’ll determine the specific value it brings to customers — in this case, exceptional quality and positive social impact. We can identify the value-theory TAM by estimating how much customers would be willing to pay for a superior product. If a standard cup of coffee sells for $3, would customers be willing to pay $5 or even $7 to sip the finest and fairest?

This research could involve conducting surveys, studying competitors and analyzing market expectations. Let’s assume we discover that customers are willing to pay $6 for a cup of coffee that delivers exceptional quality steeped in environmental and social progress. Say research indicates there are 100,000 potential customers in the local area who would appreciate the distinctive quality of the coffee and are willing to pay a premium for it.

To find the value-theory TAM, multiply the number of potential customers by the estimated average value they associate with the product.

TAM = Average amount customers are willing to pay × Number of potential customers
TAM = $6 × 100,000 = $600,000

The value-theory approach gives us another high-level overview of a specific product, without considering the business's current sales data or customer base. Instead, it focuses on understanding the perceived value of a specific product and customers’ willingness to pay for its unique benefits. By aligning the coffee shop’s value proposition with customer expectations, we can arrive at valuable insights into the sustainability and profitability of the business.

 

Before you run with it, research

Whichever approach you choose, you may need to conduct further research that’s specific to your business. You could conduct surveys or interviews, perform more specialized market analysis or take a deeper dive into your target market or existing competition.

While the thrill of a new business venture can be enticing, it’s important to first understand what’s realistically attainable. Consider your TAM another tool in your toolkit, helping you fine-tune your unique selling points to launch a product or service that’s built to last and poised for success.

For more support for growing and sustaining your business, reach out to a Chase business banker today.