How Big Can Your Business Be? Grow to meet your Addressable Market

(Will your company be too small to succeed?)

You have a business — or an idea for a business.  But do you have any idea how big your business can grow?

It’s an important question.  From the very first day, a McDonald’s-sized restaurant does things very differently than a local burger shop, right?  I mean, a local burger shop won’t be investing in Super Bowl advertising the way a giant brand might.

So, how do you decide how much to invest in advertising, inventory, staff… even rent?  It comes back to how BIG can you BECOME, and the answer to that takes some simple math.

Technically, the answer is called your “Total Addressable Market,” or TAM.   That’s a good word to use in front of your banker, but it’s simpler than it sounds.

TAM is value of all the sales you could make if you had no competition.

• ALL the sales? Right.  If all the people who are already looking for your product bought only from you, how many customers would you have?
• NO competition? Yes.  This is imaginary, remember, so there are no competitors, no substitutions, and no alternatives.  If you have a restaurant, pretend it is the ONLY restaurant in town.

What’s the Catch?

I know you’re getting excited now.  If you own the only restaurant in town, the customers would be lined up at the door all day and all night, right?  Not so fast.

• Your “Potential Customers” are actually fewer than you think. Notice that we said you had the only restaurant IN TOWN.  Exclude people who live more than 10 or 20 miles away… and people who always eat at home.  And if you happen to be a Brazilian Steak House, do not include vegetarians!  Start carving out the people who are NOT potential customers, and the line outside your door may start looking shorter.
• You have other limitations.  How many seats in your restaurant? What hours are you open?  If each person takes an hour to eat, you’ll be limited in how many total people can you ACTUALLY serve.

Now we’re getting some where. The Total Addressable Market for a restaurant chain might be very big, but the TAM for a single restaurant is probably very small.

The Lesson?
Don’t spend $10 million building and advertising a restaurant if you can only ever serve $1,000 worth of dinners.

In most cases, a quick TAM calculation can put your business into clear perspective.  When doing this, you don’t even have to think about things like profit margin or cost of raw materials…  just use your TAM to get an idea of scope and scale.  Let it guide your total size.

What TAM is not…
Your TAM is not the same as your “industry”… TAM is much smaller.   If you are a restaurant, you are part of the trillion-dollar food service industry, but clearly, you could not sell a trillion dollars worth of steak and sandwiches!

TAM is not “market share”… TAM is much bigger.   General Motors may have 30% market share for SUV’s in the USA, but their TAM includes all the people who buy Ford Explorers or Honda CRV’s.

TAM is not your “Target Market”, which tends to mean the descriptive demographics of your ultimate customer. Nor is it your “Market Segment” which is a description of a subset of your “industry”. Rather than describing your customers, TAM is generally expressed as a value in dollars.

Examples of Addressable Market

Let’s use the auto industry.  Imagine a “Muffler Co.” that makes specialty mufflers for luxury sedans.  To calculate Muffler Co.’s Total Addressable Market, we need to know how many manufacturers make luxury sedans, and how many cars each one makes.  We can count up all the BMW’s plus all the Cadillacs plus all the Lincolns and Mercedes and so forth.  The total number of mufflers needed for ALL those cars is the Muffler Co.’s TAM.  Usually, we express this in either units (number of mufflers) or dollars (value of selling all those mufflers).

Note that the muffler company’s TAM is not the trillion-dollar automobile market since they only make mufflers.  Nor is it market for all mufflers on all cars, since their product is only designed for luxury sedans!

If adding up all the luxury sedans made in a year seems like too much work, the company might be tempted to find an industry number for all luxury sedan mufflers sold.  Sometimes that’s a good shortcut. But beware – if that number includes the mufflers installed on luxury sedans at repair shops then it’s not a good representation of the true TAM.  Remember, we originally defined our customer only as the auto manufacturers.  To include these after-market sales means we would have to redefine our customer… and that will change our whole business plan!

Example Addressable Market #2

Lets try one more example.  A butcher wants to sell prime filet mignon to all the restaurants in Ohio.  Sounds like a good idea, right?  After all, research shows that there are 10,000 restaurants in Ohio spending over $100 million a year on beef.  That’s a sizeable TAM, and a great opportunity, isn’t it?

Not so fast.  Clearly, by packaging and selling filet mignon, the company can’t serve restaurants like McDonald’s and Pizza Hut.  As it turns out, fast food chains like those represent 60% of the restaurant market.  Ooops!  All of a sudden your $100 million beef market is reduced by products you don’t sell — like ground chuck and pepperoni sausage, not filet mignon.

Perhaps you will find that steaks represent just 30% of the beef market… and filet mignon represents just 10% of the steak market.  Suddenly your Total Addressable Market is just 3% (30% x 10% = 3%) of what you thought it was.

How TAM Impacts Your Business Decisions
Use this to know how much farm land to buy, how many cows to raise, or how much to invest in advertising.

Clearly, it would make very little sense to pour $10,000 into advertising in a local area that only spends $5,000 a year on filet mignon (or mufflers, or steak restaurants).  Likewise, an investor in the Ohio Filet Mignon Company will want to know how you plan to repay his $5 million investment out of your slice of just a $3 million total market!

Remember: Keep an eye on your true TAM, and let that determine the scope and scale of your business.  Don’t grow out of your TAM until you have your next market already defined!

Dedicated to your (addressable) profits, David

PS:  Want to define YOUR TAM? We’re available to answer questions and help you with calculations.  Contact a Rock Solid CFO today… or get the book and learn about TAM and 52 other key ratios for growing your business.

photo credit: Darwin Bell via photopin cc