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A TAM calculation can help you predict revenue growth, figure out how profitable your business can be and the level of funding you should be taking on to grow your business. — Getty Images/eclipse_images

You may believe in your new business or product idea, but it’s hard to know how many potential customers will be interested. Doing a total addressable market calculation can help you determine the growth potential for your new company.

[Read more: Startup 2021: 3 Easy Steps to Research Your Business Idea]

What is a total addressable market calculation?

Your business’s total addressable market (TAM) is the total demand for the products or services you offer. It’s the upper limit of how much your business can expect to earn in a specific market if you received 100% of that market.

A total addressable market calculation can help you predict revenue growth and figure out how profitable your business can be in that industry. It can also help you figure out the level of funding you should be taking on to grow your business.

However, since you’re going to have competitors, there is no way you can capture 100% of the total addressable market. So another term you’ll want to familiarize yourself with is market share.

If you imagine TAM as a giant pie, you’ll have to share pieces of that pie with your competitors. Your piece of the pie is your market share, and the more competitors you have, the smaller your share of the market will be.

[Read more: How to Start an Online Business: 5 Easy Steps to Follow]

But what if your business is trying to expand into a new product or service, and you’re trying to figure out how to cross-sell current customers? In this situation, value theory analysis can be helpful.

How to figure out your TAM

Let’s look at three strategies you can use to figure out the total addressable market:

Top-down analysis

With top-down analysis, you start with the largest possible estimate and then narrow it down using information about your business. For instance, let’s say you’re starting an online women’s clothing boutique.

You might start by using research from Forrester, Gardner, or other consulting groups to determine how big the e-commerce market is. Of course, not every e-commerce customer will want to purchase women’s clothing, so you can use third-party data to further narrow it down from there.

Top-down analysis is usually represented by an upside-down pyramid that represents the larger population at the top and the smaller segment at the bottom. It’s not a bad place to start, but it does have its downsides.

First, you have to rely on information from third-party analysts, which may not be entirely accurate or up to date. And the research that’s already been done may not represent the exact specifications of your addressable market.

If you decide to use top-down analysis, it’s best to hire your own market research consulting firm. That company can conduct research that is specific to your company and industry.

Bottom-up analysis

Bottom-up analysis is more accurate because it relies on your own company data. Here is the calculation you’ll use:

(Total Number of Customers) X (Annual Contract Value) = TAM

You’ll start by multiplying your average sales price by the number of total current customers. This number is your annual contract value. From there, you’ll multiply your annual contract value by the total customers and get your TAM.

The bottom-up analysis is the preferred way to determine your TAM because it uses actual data on pricing and the use of your product. Instead of just sharing general third-party statistics, you have information about the types of customers your business can expect to serve.

Value theory analysis

One of the limitations of top-down and bottom-up analysis is that both methods look at existing information and assume a new product offering will fit into them.

But what if your business is trying to expand into a new product or service, and you’re trying to figure out how to cross-sell current customers? In this situation, value theory analysis can be helpful.

Value theory analysis looks at how much value customers will receive from your product or service and what they’ll be willing to pay for that value. There’s a lot of guesswork that goes into value theory analysis, but it can be a helpful tool.

To get started, you’ll estimate the value your product brings to a user and how that will be captured through pricing. It’s an excellent way to look at what customers find valuable and what they’ll be willing to pay for.

[Read more: Need Some Feedback? How to Conduct Customer Interviews and Focus Groups]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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Published June 01, 2021