When you’re considering a new venture, one of the first things you should do is determine whether there is a valuable market for it.
There are several reasons why every business should spend time sizing its market:
It helps you determine if it’s a worthy investment – Say you have a great idea for a product but there are currently only 100 people who would buy it. From there, you can decide if that population size is worth the cost of manufacturing, production, distribution, and more for your product.
It helps you estimate maximum total profit – If you know how many people your business has the potential to reach, you can estimate how much revenue you can generate. This is valuable for both business owners as well as investors.
The first is a top-down approach, in which you start by looking at the market as a whole, from a bird’s eye view, then refine it to get an accurate market size. That would look like starting from your total addressable market and filtering from there.
Let’s say you want to launch a wine company. First, you’d want to determine how many liquor stores are in the United States — this helps you figure out the total market to which you could theoretically sell your product.
After your research, you discover there are 50,000 liquor stores in the United States. Of that total list, you only want to sell to the New England area — including Massachusetts, Maine, and Rhode Island.
You determine your target market includes the 1,000 liquor stores in the New England area. From here, you conduct research and speak with alcohol distributors to determine there’s a roughly 40% success rate for wine distribution.
Using this as an example, we’d calculate the market size using the following formula:
1,000 liquor stores x 40% = 400 liquor stores
Then, if you assume each liquor store will result in $20,000, you can figure out potential revenue using the following formula:
400 liquor stores x $20,000 = $8,000,000
This means you stand to make $8 million if you penetrate 40% of the total market in the New England area.
A bottom-up approach is the exact opposite – starting small and working your way outward.
This looks like first identifying the number of units you can expect to sell then considering how many sales you anticipate from each buyer and finally the average price per unit.
Using the same wine example – Say you found recent data showing that the average cost of a wine bottle in New England is $10. A survey shows that the average consumer buys one bottle of wine a week, or 48 bottles a year. This means that the average consumer spends $480 per year on wine.
Next, you discover that the number of consumers (or households) you can expect to reach in the New England area is 16,000.
As a result, your market size is 480 x 16,000 = $8,000,000.
It’s important to note that both methods ignore the existence of competitors, customer churn rate, and other factors that impact sales. With this in mind, you’ll want to remain conservative when estimating how much of the market size you’ll win and use this as a starting point.
You have your estimated market size — now what?
Market size helps your business answer the following questions:
How much potential revenue can we earn from this particular market? In other words, is it even worth our time and energy?
Is the market big enough to interest us?
Is the market growing? Will there still be opportunities to earn revenue from this market in 3, 5, 10 years?
Market size is a critical number to know when you’re looking for funding. Investors are going to need to know how much money they have the potential to make from a given market. Additionally, it’s vital to recognize whether the potential revenue you can make outweighs your business’ costs.
Once you have market size, you’ll also want to consider how saturated the market already is with your competitors’ products.
Ultimately, you can’t capture the total addressable market (TAM) — some of those people will choose competitors’ products over yours. So you’ll need to determine whether you have a shot at earning enough consumers out of the TAM to make this a worthwhile venture.
Editor’s Note: This post was originally published in April 2019 and has been updated for comprehensiveness.