Total Addressable Market gives you a better understanding of the market size and revenue opportunity if you cover 100% market share.
It is common to hear the phrase Total Addressable Market or TAM when it comes to business planning. There is no doubt that you will hear this buzzword at some point. But what exactly does it mean? And how is it useful in business?
In this article, you’ll understand how easy it can be to calculate your TAM and how you can get started calculating it.
Let’s get started.
What is Total Addressable Market (TAM)?
Total Addressable Market denotes the maximum revenue opportunity for a product or a service in a given market category. It helps business owners and investors understand how big is the potential market that they can cover.
Additionally, TAM helps startup founders determine the valuation of the company and the funding required to grow the company. It gives meaningful insights like estimating the marketing spend, targeting different customer segments, probable customer acquisition spend, and so on.
TAM takes into account the products and customer segments that the startup hasn’t yet explored. By assessing the startup’s market opportunity and prevailing competition, the assessment helps to determine the actual market size.
Why is TAM Important?
Starting a business and estimating the profit beforehand always feels exciting. However, a vague approach to gauging the market size can make or break your business.
TAM gives you a realistic market size for a business category you wish to enter. It’s an important metric that helps you decide whether to enter within an existing customer segment or enter with a new strategy.
Investors are always keen to know the TAM to ensure whether they’re investing in a growing business. The hyped market size may lead to wrong strategic decisions impacting your business revenue and estimated growth. Calculating TAM encourages founders to deep dive into their products to see if they fit anywhere in a competitive market.
It also helps in breaking down the key unit economics for your product. For example, the market size gives you an idea of the product price, manufacturing cost, logistic infrastructure, average order per customer, profit per sale, and many more.
How to Calculate TAM?
Calculating TAM in terms of a mathematical formula looks simple.
Simply put, it’s the product of Average revenue per user(ARPU) and the total number of potential customers available in the target market.
Here is the formula for predicting Total Addressable Market:
TAM = ARPU * a Total number of potential customers.
Although it looks easy, calculating the total count of potential users in the actual market is trickier. While these on-paper statistics can serve as a starting point, other methods help realistically estimate TAM.
Here are four popular methods used for calculating Total Addressable Market:
- Value Theory
- External Research Firms
Let’s understand each technique in detail.
The top-down method, first on our list, uses a narrowing-down approach.
At the start of the process, it considers the total number of probable customers from the target market. After that, it narrows down to a more niche market segment by eliminating users based on demographic and other factors.
If we draw a top-down approach diagram, it looks similar to an inverted pyramid. The top portion of the pyramid denotes a majority of the user base, and that is narrowed down to a specific audience segment.
The elimination process involves plenty of assumptions and dependency on available data that do not always indicate any future trends. For example, it does not take into consideration a product that can disrupt the existing industry standards.
The bottom-up method uses a better approach because it uses reliable data and a small target market. Here, the company takes a base price along with an initial setup of customers and then scales up the projection to cover the total market.
It’s useful because the data collected at the owner’s end is based on personal experience rather than relying on third-party agency data sets. It also eliminates the guesswork that’s present in the top-down method.
Going by the name, the Value theory estimates the total addressable market by considering the value provided by a product to the end customer. Generally, product pricing reflects how much a typical buyer is willing to spend in exchange for getting value from the product.
When new products are introduced in a market or certain products are cross-sold to existing customers, a company uses value theory to calculate TAM. Value Theory works best when applied to a novice product creating a new category in an existing market and trying to bring in additional value compared to existing players.
The final result is the product of the total number of users and the purchase price they pay to adopt the product.
External Research Firms
Gartner and IDC publish reports that often postulate on sectoral TAMs. Data are professionally compiled, credible, and easy to find; nonetheless, it can compromise your ability to gain a deeper understanding of your market through proprietary research.
These companies make use of either top-down or bottom-up methods to check the customer base dynamics of the product or service. These companies have a capable workforce experienced in defining and calculating the actual number of potential users inside the total market. This new sphere of actual users defines a new addressable market.
Understanding SAM and SOM
Total Addressable Market (TAM) represents the maximum potential customer base that a product or a service can cater to. However, some other terms come under TAM that help you get a ground-level number of customers.
Now that you have got a better understanding of the Total Addressable Market, it’s time to look at crucial aspects like SAM and SOM.
What is SAM?
Serviceable Available Market, abbreviated SAM, is a subset of the Total Addressable Market. To put it in simple words, it represents a real portion of the target market served by a business product or service.
If we carefully analyze the business opportunity market, it is only possible to capture a part of the market share due to competitor presence.
Besides, some other essential factors that determine SAM include geographic reasons, user demographics, regional rules and regulations, business laws, product cannibalization, the introduction of new product categories, and so on.
What Is SOM?
Serviceable Obtainable Market(SOM) is a subset of SAM. Basically, it represents how much of the SAM a business product or service can realistically achieve.
SOM is the most critical aspect a company focuses on, and it involves a lot of market research. For example, analyzing the SAM performance based on different geographic reposts and then coming up with performance marketing initiatives to optimize the SOM in a particular local market.
From the above line, it’s clear that optimizing the SOM value depends on a company’s execution. The percentage of SOM also depends on the company’s resources, financial capabilities, and competitiveness in the market.
Difference between TAM, SAM, and SOM
TAM represents the entire market share for a business product or a service. Whereas SAM and SOM are subsets of the Total Addressable Market. If we plot a Venn diagram, you’ll find that SOM covers the least market share that falls under SAM.
Consider the following example:
According to recent data, the United States automobile market is an example of the Total Addressable Market, with an estimated value of $104.1 billion in 2023, which is expected to grow at 25% CAGR every year. This market includes the two-wheeler segment, heavy vehicles, and electric vehicles.
The introduction of electric vehicles in recent years has created a new category in the automobile industry. This newly coined category represents Serviceable Available Market (SAM).
The EV category itself is estimated to reach US$ 137.43 billion by 2028 in the United States. As a result, a lot of new manufacturers, suppliers, and retailers are participating to take early advantage of this opportunity. A section of the EV industry served by a manufacturer is an example of a Serviceable obtainable market (SOM).
Benefits of Understanding TAM
Calculating TAM before pondering on a new business opportunity provides entrepreneurs with a solid base for product strategy and execution.
Here are a few reasons why an entrepreneur should spend a good time calculating TAM:
Understanding Growth: TAM helps businesses understand how they can expand product capability and geographic reach at scale.
Estimating Revenues: Often, total addressable market numbers are hyped or misleading. If analyzed correctly, TAM can help you forecast realistic revenue and profit numbers.
Investment: It helps determine whether someone or a company should invest money and effort in a new business venture and how much return on investment they can expect.
Gap Analysis: The analysis helps to find gaps in the potential market and the competition for the startup’s products.
Let’s summarize our article with key takeaway points.
TAM is a critical number for companies to understand and use. It’s pretty much about the size of the opportunity for your company. That is, TAM is the broadest scope of customers or users that you can address and get a reasonable share of them to use your product or service.
When you have the TAM, you can better understand the opportunities available for your product or service. You can also better understand how much investment is needed to win in a given market. You can also use the TAM in combination with your company data to understand how much opportunity there is to grow your business.
Looking for similar marketing articles? Check out our detailed guide on deciding your go-to-market strategy after finding TAM.