3 step approach to accurately size the market for your technology products or service.
Guide
Tips to grow your business from a Researcher.
To calculate the overall revenue opportunity for a technology or service we need to calculate the market size. This data is mostly used for go-to-market (GTM) strategies, or when presenting to potential investors. I also think it is a great thing to do when creating a new sales goal. There are great benefits of calculating the size of your market, this includes:
- Accurately show product-market-fit
- Go beyond just a revenue number but provide a deeper understanding of those accounts
- Informed targets that leads to better customer retention and higher renewal rates
- Attract investors
A failure to have a true handle on the market size through customer segmentation and competitive dynamics can lead to poor product-market fit. I will go through the 3 steps approach that I believe is most accurate to calculating market size and apply it to a few examples. At the end of this guide you should be able to calculate the market size for your product or service.
Step 1: Calculate the total available market
The total available market is a calculation that represents the overall revenue opportunity for a given set of products or services.
There are three distinct ways to calculate TAM:
- Top-down, using industry research and reports
- Bottom-up, using data from early selling efforts.
- Value theory, using conjecture about buyer willingness to pay.
To create a more defensible total market estimate, my approach is to do all three separately and then combine industry sales data and forecast with “bottom-up” data reflecting current customers behaviour and values.
Top -down
The top -down approach usually involves taking secondary market research from companies such as Forrester, Gartner or other consulting groups. These reports are often used to determine how many end users meet your market criteria, and how big that industry is. It is usually presented in the form of “According to [insert secondary market research], this [industry] is $X market”. While this will provide a great snapshot, this approach does have a few limitations. In cases where there are mixed pricing models (consider a software segment transitioning from license to SaaS pricing), the analysis can be confounded. If you are bringing a disruptive product to market it assumes that disruption won’t change the size of the TAM meaningfully, which is often untrue.
Bottoms up
It is favored for being more accurate, because its basis is anchored around a proven data point, which can be expanded to predict the whole TAM population. One can use primary collection methods (such as a survey in a local market), or secondary research (news reports, company filings).If you are already making sales this approach is great. This solution uses your own company data to build reliable market boundaries and sales goals. To calculate your market size using a Bottom-Up approach, multiply the total number of accounts in your industry by the annual contract value (ACV) of your company service or product. This approach relies on good data from your sales and a good estimation on the number of accounts available.
TAM = (Total # of Accounts) x (Annual Contract Value [ACV])
For example, suppose my beverage company sold wine at an average of $300 a case to vendors; they bought 50 cases per year, on average (ACV of $15,000); and there are 1,000 vendors in the city total. I can calculate TAM for my wines: 1,000 vendors multiplied by $15000 equals a total market of $15,000,000.
A disadvantage of the bottom-up method is that due to the vast assumptions being made from a figuratively small subset, the TAM can be way off.
Value-theory
Here is where the fun begins! We hear the term disruptors often. If your product or service is disrupting an industry it may be difficult to use current industry data to calculate your market. For products or services that can evolve a market into a new state and/or provide value-add to different groups of consumers, the value theory may be the best option.You may need to think of the value you add to calculate your market. A value-theory TAM relies on an estimate of the value provided to a set of users by the product, as well as a guess at how much of that value creation can be captured through pricing. Here are some questions to ask when assessing for value:
- What are the characteristics of our current and potential customers?
- What options are they currently using instead of my solution?
- How much would a user pay for insert your value instead of what they are doing now?
- Where is growth expected?
Here is how we might estimate Door Dash’s TAM using value. We’d consider the use case, restaurant, in which users choose between alternatives including dining out, take out or ordering in. Notice that food delivery service has the potential to draw from ALL of these buckets.We might look at restaurant customer data and ask the theoretical question: “how much would a user pay to have food delivered from different restaurants instead of X?” and solve for a number.
Step 2 -Refine available market estimate into total serviceable markets/ service addressable market (SAM)
Knowing the total available market is important but it’s highly unlikely you will be able to service the entire available market. You need to drill down to arrive at your serviceable market estimate, gauge how many customers are expected to buy either as early adopters or as more mainstream adopters in your targeted market. To calculate your serviceable addressable market, count up all the potential customers that would be a good fit for your business and multiply that number by the average annual revenue of these types of customers in your market.
SAM = (# of Accounts in a marketplace) x (Annual Contract Value [ACV])
Step 3 Focus on actual financial impacts from the Serviceable Obtainable Market (SOM)
The SOM should represent what your company can realistically expect to achieve in the target market. When doing this calculation you must account for implementation factors such as; marketing and sales channel, your distribution structure and operations. With an honest and transparent internal assessment, you can now derive a market segment opportunity calculation that sets realistic expectations of likely business opportunity.
SOM = (previous year market share) x (this year’s SAM)
The previous year’s market share is calculated by dividing your previous year’s revenue by your previous year’s SAM.
Although these calculations are estimates they provide a guiding post and can be refined with ongoing research and data analysis.
Lets practice these calculations with an example
Calculate the market size for an Australian Shiraz blend entering the Ontario wine market
Step 1 Calculate TAM
Since this is a bid to get more of a product into the market. I will use a top down approach. The sales from the mini introduction would be too small to extend to the larger market. The value method could be appropriate being that it is a unique blend but the subjective nature may delve us into wine theory and that’s not what we want to do today. Here is the top down rationale I am using step by step:
- In 2019 Total ($ in thousands) of imported wines sold in Ontario
1,817,043 - Total Red wine buyers in Ontario In 2019
We will estimate that half of buyers are red wine drinkers 908,521.50 - To predict TAM for red wine drinkers in 2020 we will calculate the total spend x the growth over year (3.2%).
TAM= 937,594
Average consumer spends $1440 a year on wine and we will estimate half on red $720 (ACV) so the total # of accounts in the red wine imported market 1302.2
Step 2 Calculate SAM
SAM = (# of Accounts in a marketplace) x (Annual Contract Value [ACV])
- Australia wines hold about 12.7 per cent share of the imported red wine segment
- SAM = 165.38 x 720=119,074
Step 3 Calculate SOM
SOM = (previous year market share) x (this year’s SAM)
The previous year’s market share is calculated by dividing your previous year’s revenue by your previous year’s SAM.
Let’s say this company previous market share was 0.1
SOM= 0.1 x 119,074=11,907.4
Sales Data: Canada; LCBO; 2010 to 2019; Fiscal year ending March 31 of each year
