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When, Why, and How to Calculate Potential Market
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When, Why, and How to Calculate Potential Market
I received an email from somebody asking me how to calculate TAM, which is “total addressable market,” (don’t feel bad if you didn’t know the acronym, because I didn’t either; I had to look it up). I’ve always called that simply “potential market.” As far as I’m concerned, these are the same thing. I’m going to call it potential market here, in this post.
Regardless of what term you use, understand that these numbers are stories, possibilities, and hopes, not facts. They’re useful because they give a business plan a sense of scale. People want to know how big this opportunity is and how big it can get. But market size is relative, markets change quickly, definitions are very fluid, so market numbers are educated guesses at best.
Market Forecast and Potential Market
For a general review of what a market forecast it, and how to do one, I’d recommend this link to an article I wrote called what is a market forecast*. A market forecast is almost always looking at potential market, not market share, realized market, or sales; potential market is almost always a large number.
Identifying Your Potential Market – Industry Examples
Normally to calculate potential market you start with a large number and then narrow it down. It’s a lot like taking a pie and slicing pieces off of it.
The potential market for business planning software, for example, would start with all people who have access to computers that can run the software. You’d have to quickly cut out people who are too young or too old, people whose computers don’t have the right operating system, people who can deal with the languages supported by the software. And then you’d want to narrow that down to people who are interested in business and, still cutting off pieces, people who want to do business planning using software.
When I was writing for Business Week out of Mexico City, years ago, the head of an American pharmaceutical company operating in Mexico told me that his marketing team believed that less than half of the population of the country (that was 30 years ago) was really part of the market for aspirin. The rest either couldn’t afford them or would never take a pill for a headache.
So the potential market for shoes is people who wear shoes and have money to buy them, but the potential market for athletic shoes is a subset of that, and the potential market for high heels, or ski boots, or children’s shoes, are also subsets.
Some web marketing companies like to think their potential is the whole world; but it’s really people who have access to the web, who can order with shipping, who can read the website, and have credit cards. Right?
Potential Market versus Market Share
In all these cases you start with the large pie and cut off slices that don’t apply. And in all these cases you can see that the potential market is always way bigger than the actual served market, or market share, or actual sales. Nobody ever gets a large percentage of any potential market.
Take a minute to think of the largest, most successful marketing brand you’ve ever heard of, and then think of the potential market, and then how much of it they actually get. Take McDonald’s, for example, with all the billions of hamburgers they’ve served, with a potential market equal to roughly that portion of the entire world’s population that can get to a McDonald’s restaurant, how much of that do they actually get? It’s tiny, wouldn’t you agree?
When it comes to potential market, proceed with caution
All of which argues for taking potential market numbers with a great deal of skepticism. While the big potential market number is nice to have, it rarely has much relevance to real business, and particularly not startups.
Markets are relative. Whatever the potential market for video game software is, for example, it’s obviously way bigger than the market for business planning software. When a new venture comes up with something that everybody can use, and wants to use, that’s obviously way bigger than the venture that solves the problem of, say, working with quadratic equations in spreadsheets.
Whey potential market doesn’t always impress investors
Ironically, when you take the concept of potential market into battle as part of a business plan or presentation, what works best is more story than number. The phrase “a $4.3 billion market” means so much less to investors than “we’re going to change the way people buy shoes” or “we’re going to end sore feet.”
Focus on how you’ll get a piece of the market
And the least useful market sizing trick is the one that focuses on a new company getting a small piece of a very big market. I see this one way too often in investment pitches and business plan competitions. Don’t ever tell investors you’re going to get a very small piece of a very large market.
Instead, build your sales forecast from the details up, channel by channel, search term by search term, store by store, or customer by customer, to make them credible. A large market is great, but when you get into defining total potential market, every business has a large market. What you’re going to do to get a piece of it is much more interesting.
About the Author:
Founder and Chairman of Palo Alto Software and bplans.com, on twitter as Timberry, blogging at timberry.bplans.com. His collected posts are at blog.timberry.com. Stanford MBA. Married 44 years, father of 5. Author of business plan software Business Plan Pro and www.liveplan.com and books including The Plan As You Go Business Plan, published by Entrepreneur Press, 2008.