Entrepreneurs often burst with ideas: new businesses, innovative products, or areas to expand their existing companies. Yet, not all ideas translate into shrewd, profitable business moves. How can you decide which ideas to execute—and which to leave in drafts?
Market sizing helps you understand where your business has the biggest financial opportunity and who your customers are. Learn what market size is, why it matters, and how to calculate it.
What is market size?
Market size is the total number of potential customers for a type of product or service. Your market size generally represents your company’s market potential—its estimated total potential revenue.
Market sizing uses a top-down, bottom-up, or value theory approach:
Top-down
A top-down approach to market sizing starts with research about a broad overall market and works down to your niche. For example, a luxury vegan perfume retailer would begin by understanding its opportunity in the overall fragrance market, then strip out several customer segments—like those in income brackets unlikely to pay their price point or disinterested in vegan ingredients.
Bottom-up
Bottom-up market sizing starts with your company’s narrow segment and works up to total market volume. That perfume seller would identify a well-defined target market segment—for example, women ages 25 to 45 who make more than $100,000 a year—and estimate the number of potential customers within that segment. They would leverage their previous sales reports (or those of competitors) to determine the average revenue per customer, multiply that by the number of potential customers, and then repeat for all relevant customer segments.
Value theory
Value theory focuses on your product or service’s unique value proposition (UVP)—the competitive advantage that differentiates you from competitors. The perfume company could analyze the total population that would benefit from its value proposition, and multiply that by an estimate of the maximum price those customers would be willing to pay to address a need—for example, a perfume made with no animal testing or ingredients.
Estimating market size is a nuanced process that doesn’t guarantee future business growth, but it’s a powerful tool to guide decisions as your company matures.
Why should you research market size?
A solid grasp of market sizing and its nuances can help your business achieve profitable growth:
Understand new and existing customers
Market size research generates internal and external customer data that provides a deeper understanding of current and future customers’ preferences, needs, and buying patterns. As your business grows and matures, this knowledge of your customers can serve as a North Star, ensuring your strategy remains on track.
Market sizing also helps identify multiple expansion opportunities, including additional customer segments. As you analyze customer characteristics like age groups and income levels to determine overall market size, you may find new groups of people who fit and, in turn, shape your ideal customer profile—the type of customer likely to buy your product.
Guide expansion strategy
Understanding market size helps guide your growth strategy. Factors like distribution capabilities, shipping networks, and local market regulations help you evaluate the regions your business can realistically serve. Your overall and regional market capacity determines your ability to set realistic, achievable sales targets, informing your budgets and priorities.
By learning your operational scope and reach, you might identify opportunities to serve a new local market better or, combined with better customer insight, create new product lines that can increase the market value of your existing customers and attract new buyers to your brand.
For example, you might establish a fulfillment center specializing in a new line of products to expand your SAM, helping expedite shipping to existing customers and expanding your reach into new areas with untapped customers.
Secure investment
Investors, like venture capitalists, look for companies with the potential to grow, making it critical to demonstrate your market opportunity and unique positioning to benefit. Market sizing helps you substantiate current customer demand, future market stability or growth, and your company’s ability to acquire that potential business.
For example, say you own an organic dog food business. You could show investors:
1. People became dog owners at an increased rate over the past five years.
2. This group is increasingly interested in high-quality and organic ingredients.
3. A large part of this group is unable or unwilling to consistently pay the competition’s high prices.
You’ve strategically optimized your supply chain, built relationships with suppliers that lead to favorable contracts, and established warehouses in multiple areas to reduce shipping costs. You can offer high-quality organic dog food 20% cheaper than your competitors, positioning your business to capture buyers outside top income brackets as the overall market grows.
How to calculate market size
- Assess your target customers and the broader market
- Collect internal company data
- Calculate TAM
- Calculate SAM
- Calculate SOM
Determine market size by analyzing internal company data and external market research and calculating different levels of market potential. Here’s what you need to know:
1. Assess your target market and the broader market
Accurate market size calculations require accurate identification of your target audience and market.
Consider factors from your ideal customer profile, including age, interests, location, and spending power. Conduct market research with platforms like Nielsen and Gartner to collect external information like industry trends, market size data, total annual sales, customer demand, competitive market share data, customer acquisition costs, and average order values.
Leverage government census data to uncover rich information about your potential target customers. Census reports include valuable information about residents’ education, employment, health, and more.
If you have existing customers, survey them about purchasing power, brand preferences, and price sensitivity.
2. Collect internal company data
Several market sizing calculations use details from your company’s historical performance. Gather your company’s total annual revenue, the size of various customer segments, and average revenue per customer (ARPC). ARPC measures how much revenue you’re generating—or expect to generate—for each active customer. Here’s how to calculate it:
ARPC = Total revenue / Total number of customers during the measurement period
If your company is new and has no sales yet, use market research and public information from competitors to make estimates for these figures. These numbers will also inform the following three market size calculations.
3. Calculate TAM
The total addressable market (TAM) is the entire potential market for your product—a hypothetical scenario in which you could reach every possible customer. In reality, competition and logistics considerations mean no single company could ever capture all market demand, but TAM is a good starting point. TAM calculations typically use a top-down approach:
TAM = Total number of potential customers x Average revenue per customer (ARPC)
So, if your ARPC is $25 and your market has 20,000 potential customers, your company’s TAM would be $500,000 (20,000 x $25). You can also calculate TAM using a bottom-up or value theory approach.
4. Calculate SAM
Narrow down your TAM by calculating your serviceable addressable market (SAM)—the portion of possible customers your company can realistically reach and serve. SAM considers data points like customers’ geographic location and your product’s price point but excludes market forces like competition. Subtract customer segments your company won’t reach from your TAM, then multiply by ARPC:
SAM = Total target segment of TAM x Average revenue per customer
For example, when calculating its TAM, the luxury vegan perfume retailer will start with the overall fragrance market. To find the target segment for the SAM formula, it would then subtract customers who are:
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In geographic locations the company can’t serve
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In income brackets unlikely to pay their price point
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Not interested in vegan-derived or luxury fragrances
5. Calculate SOM
Narrow down your SAM by calculating your serviceable obtainable market (SOM)—the realistic market share you can expect for your specific product, taking into account more granular factors like your historical business performance, brand awareness, and competition.
To calculate SOM, determine your market share by dividing last year’s revenue by the previous year’s SAM. Then, take that percentage for last year’s market share and multiply it by the current year’s SAM:
SOM = Last year’s market share % x This year’s SAM
For example, the luxury vegan perfume brand identifies last year’s SAM at $100 million, based on the customers it can feasibly reach. The company recorded $2 million in sales the previous year. Last year’s market share is:
0.02% market share = $2 million in revenue / $100 million SAM
The brand determines that this year’s SAM increased to $125 million, thanks to market growth. This year’s SOM, then, would be:
$2.5 million SOM = 0.02% market share x $125 million SAM
SOM is the last layer of market size analysis and provides an important guideline for market research and overall business strategy. It helps you evaluate the potential revenue of a particular product or service and identify opportunities for targeted sales tactics and marketing strategies.
Market size FAQ
What’s an example of market size calculation?
For the overall total addressable market (TAM), a hypothetical calculation of how many potential customers you could reach in the entire market for your product, the formula is:
TAM = Total number of potential customers x Average revenue per customer.
How do you measure market size?
Market size is the number of people in a market segment who could become your company’s customers or the total revenue those customers could generate. You can calculate your market size using a top-down, bottom-up, or value theory approach.
What are the types of market size?
Market size categories can include total addressable market (TAM), serviceable addressable market (SAM), and serviceable obtainable market (SOM).