Calculating the market size is one of the most important steps before starting any business. The market size determines the attractiveness and the potential of success and helps founders make an easier decision about entering the market.
Market size represents the total volume of the potential market that exists and is usually calculated over one year.
It’s Important to Calculate And Understand Market Size.
One of the most important factors for investors to consider before funding a startup is the market size. In fact, the investor decides whether to invest in a business based on the available market size (TAM). Also, the market size has a significant impact on the startup valuation. So if you need to raise capital to grow your startup, you should estimate the size of your market from the very beginning.
Even if you do not need to raise capital, calculating the size of the market will help you make strategic decisions. For example, knowing the size of the market plays an essential role in the following cases:
- Startup financial forecasting and marketing budgeting
- Product development
- Designing the organizational structure to determine the key skills required
- Planning for future partnerships
In pre-established industries, market size is easy to calculate. Still, for startups that offer new value propositions, there is not enough information about potential customers, their purchasing power, and so on.
Thus, how can the founders calculate the size of the market in newly founded fields as well as ever-changing markets?
How to Calculate Market Size
As you will see, calculating the market size requires creativity as it involves raising various assumptions at different stages.
However, the starting point in calculating market size is answering the following question:
“What problem is the startup going to solve?”
Many founders are initially so obsessed with the product and its features that they forget how the product benefits potential customers. In fact, by defining the problems that the startup will solve, you can more easily identify the target customers and thus obtain their number.
The following are two main approaches to calculating market size:
- Top-down analysis (using macro reports and statistical research)
- Bottom-up analysis (using internal startup data)
Top-Down Analysis
As the name implies, in a top-down approach, you should start with the largest market size and, based on the business and market information and assumptions, step by step reduce it to reach the final figure.
For example, suppose a startup whose primary value proposition is to provide online fruit shopping services. To calculate the market size using a top-down approach, you first need to calculate how much people are currently spending on fruit.
Using big statistics, you can get the total cost of buying fruit in a year. Suppose this number is at $ 40 million, however, not all people buy fruit online. On the other hand, it is not operationally possible to serve all of them.
Suppose online fruit shopping can provide services only in large cities. In that case, you should obtain the ratio of the large cities population to the country’s total population to adjust the last number. For example, if 25% of the country’s population lives in large cities, the previous number should be divided by 4.
Next, you need to remind yourself that not all people buy their fruit online. Supermarkets and fruit shops still have a large share in fruit supply. Assuming that one-fifth of people buy fruit online, the previous number should be divided into five. Eventually, we can say the size of the online fruit market is $ 2 million.
If any adjustment is underestimated intentionally or accidentally, the top-down approach can lead to an overestimation of the market size. Therefore, it is better to calculate the market size using both approaches.
Bottom-Up Analysis
Although it is relatively easy to calculate the market size using the top-down approach, it can be misleading.
Is it really possible to access the whole market? Even if the answer to this question is yes, what are the costs of accessing the entire market?
Using the bottom-up method provides a good picture of the details. In this approach, by considering the current status of the startup (product, price, customers, etc.) and the scalability of each sector, you can calculate the size of the startup market.
In the case of the hypothetical startup in question, the market size is calculated as follows using bottom-up analysis.
For example, the average price for most fresh fruit is $ 0.18 per serving and $ 2.00 per pound. If people buy 10 pounds of fruit once a week, you can easily calculate the average annual fruit purchase per person.
In the next step, you need to calculate the number of customers you can reach. Based on marketing forecasts considering the effectiveness of advertising campaigns, it is possible to reach 500,000 customers in a metropolis. By multiplying that number by the average annual fruit purchase of each person, you can obtain the market size of that metropolis.
In calculating the size of the market, factors such as the time required to reach a certain number of customers, the rate of customer decline, and the competition in the market must be considered. These factors are usually considered in the next steps and during the business plan development.
Market Size Calculations Using Two Approaches Should Be Relatively Closed.
Market size calculations using two approaches (bottom-up and top-down) should be relatively closed. If they are, you can be sure you did a great job estimating your startup market size. However, if these two figures are far from each other, there is an issue, or maybe there are multiple issues somewhere. You should reconsider the hypotheses of each approach to reach close numbers finally.
Tips Help You Calculate the Market Size Accurately
Get Sure Your Calculated Market Size Is Accurate by Comparing It With Similar Businesses
After calculating the market size using the above two approaches, you can compare the calculated one with similar businesses that have gone through their growth stages. This helps you measure the accuracy of your calculations. However, if there is a significant difference between the calculated market size and what active players in that market earn, you likely had some mistakes during the process.
Different Scenarios in Market Size Calculations
Given that the estimation of market size is based on assumptions, it is better to add pessimistic, optimistic, and probabilistic scenarios to your considerations. Even a slight change in any of your assumptions can significantly change the results. Therefore, considering different scenarios will help you plan better for the future.
Updating Assumptions Over Time
The assumptions change over time. Accordingly, it is necessary to update your market size at specified intervals by implementing the new assumptions, which are more accurate than the initial ones.
Considering the Technology Adoption Life Cycle
For a technology-based startup, it is essential to consider the technology adoption life cycle.
Early adopters may become our customers in the first year, but other potential customers may not use our services until 20 years later.
Sizing Emerging Markets
In cases where the startup’s value proposition is entirely new (there are currently no customers, and there is no similar company to compare), calculating market size requires more creativity. Emerging markets are generally created in two ways:
The Startup Launches New Products That Are Set to Replace Existing Ones.
These types of startups, which are usually based on technological innovation, are relatively easy to calculate the market size. You can use the current market size and estimate the extent to which the new product can replace the existing ones.
Startup Ideas Based on Creating Entirely New Value and Demand in Customers
There are no required inputs in these markets, and it is a bit difficult to calculate the size of the market. To reach an accurate size, it is necessary to estimate the target customer’s purchasing power and then estimate how much of this power can be guided to purchase the new products.
This is why these types of businesses (such as the iPhone and Tesla) target wealthy people.
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