What Is Total Addressable Market (TAM)?
October 14, 2021
Table Of Contents
Are you fishing - or about to fish - in a pond that’s way too small to keep your company afloat?
42 percent of startups fail because of no market need for their products or services. Fortunately, there’s a powerful metric that can save you from becoming a statistic and realistically gauge the size of any market: the Total Addressable Market (TAM).
And in this article, you will learn everything you need to know about TAM to help you never lose sight of the big picture.
What is the Total Addressable Market?
Total Addressable Market (TAM) is the maximum amount of money a business can generate by selling its product in a specific market.
In other words, how much revenue would a business generate if every single prospect who found value in the product purchased that product?
Why Is Knowing Your Total Addressable Market Important?
Even though the TAM does not consider vital factors like market growth and shrinkage, it's hard to overstate the importance of this metric
Knowing the TAM can aid businesses in determining their product-market fit to match their product to its prospective customers, build accurate growth projections, and better strategize their sales and marketing efforts.
Additionally, calculating your TAM brings a lot of auxiliary benefits. Below, we cover some of them.
Gauging the Industry's Profit Potential
Not all new markets are profitable and ripe for entry. Knowing the TAM gives a business an idea of the profit potential before entering into that market. Using this data, a company can make informed decisions and manage risk.
Developing an Ideal Customer Profile
The customer has to be the center of product development. TAM comes in handy when creating an ideal customer profile (ICP) as the data on the overall market size can help the company develop a more accurate ICP.
Segmenting Your Audience into Different Groups
The birds-eye view of a market that the TAM metric provides makes market segmentation easier. Since it gives a general overview and includes all potential customers, TAM offers an excellent starting point for data-driven market segmentation.
How to Calculate Your Total Addressable Market
You can calculate your TAM using a variety of techniques. However, the three universally accepted techniques are the top-down approach, the bottom-up approach, and the value theory approach.
In the top-down approach, a business starts with the largest possible estimate of the target market size and reduces it using reliable market research and reports to come up with a realistic estimate.
For example, a company that sells productivity software to offices may come up with 1,000 as the total number of offices in a given area.
Using market research, it discovers that 50% of these offices use other conventional methods to improve the output while the rest spends $5,000 on productivity software.
If you decide to opt for the top-down approach, you get the TAM of $2.5 million.
The bottom-up approach is when the company leverages the internal data on its products and pricing to determine the Annual Contract Value (ACV) and extrapolates it to estimate the size of the market.
The formula of the bottom-up approach is:
Annual Contract Value * Number of Possible Customers = TAM
Take, for example, a software company that sells 50 software licenses per year with an ACV of $2,000 in a market with the potential of selling 1,000 licenses.
The TAM equals $2 million, which is obtained by multiplying the ACV ($2,000) by the potential market amount (1,000).
Value Theory Approach
In the value theory approach, many assumptions are made in the calculation of the total addressable market. This approach is most suitable for start-ups entering new markets with novel products that offer a new value.
The TAM is calculated by using market research to estimate the potential number of clients willing and able to buy a new product and multiplying it by the price of that product.
TAM vs. SAM vs. SOM
As essential as TAM is as a market-sizing technique, it doesn’t exist in isolation. Some of its shortcomings make it necessary for companies to complement it with other metrics like SAM and SOM.
The Serviceable Available Market, or SAM, refers to the fraction of the TAM served by the product a company delivers.
For example, the global automotive industry's TAM is $2.7 trillion.
The SAM for an EV manufacturer, however, will be a fraction of that number since there’s only a certain number of people within that market willing to buy an electric vehicle.
The Serviceable Obtainable Market, abbreviated as SOM, is a more realistic market-sizing technique. It is the fraction of the SAM that is within reach for a particular product. Thus, it represents the portion of the market that you can realistically secure.
The Key Takeaway
The TAM is just another example of how crucial well-analyzed data is to an organization.
At People Data Labs, we provide organizations of all sizes with fresh and accurate market research data to empower informed decision-making.
Get in touch with us today to schedule a free consultation.
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