Estimating Product Potential
Imagine that you've just spent three years building a fantastic business – your product is great, your website is cutting edge, your people are well-trained and enthusiastic, and your customers love what you do.
The problem is, you're running at a loss – there simply aren't enough customers in the market to support the business.
This is a heartbreaking, and very common, position to be in. It's why many professional entrepreneurs and investors conduct "market sizing" exercises before they invest in a new business, as part of the business planning that they do.
In this article, we'll look at how you can analyze your market size, and how you can use this data to make informed strategic decisions.
What Is Market Sizing?
The "market size" is made up of the total number of potential buyers of a product or service within a given market, and the total revenue that these sales may generate.
It's important to calculate and understand market size for several reasons.
First, entrepreneurs and organizations can use market sizing to estimate how much profit they could potentially earn from a new business, product or service. This helps decision-makers to decide whether they should invest in it.
If you choose to move forward, this analysis will also help you to develop a marketing strategy that addresses the unique needs and potential of your core market.
Market sizing can also help you to estimate the number of people that you may need to hire before you launch a new product or service, rather than "feeling your way" as you test your new market. If you know this from the start, you can optimize your approach to recruitment, so that you have the right people in place when you need them.
Market Sizing Methods
There are two methods that are commonly used for market sizing: top-down and bottom-up.
Although the top-down method is simple, it's often unreliable and overly optimistic. It looks at the "relevant" market size for your product or service, and then calculates how much your organization might earn from it.
For example, imagine that your organization markets learning resources to schools. Your research shows that there are 6,000 relevant schools in your country. You know that the average sale per school is around US$50,000, which means that your market size is US$300 million.
Of course, this is an incredibly optimistic and unrealistic figure. Not every school needs your products, and they're unlikely to purchase $50,000 worth of goods each, so it could be a real challenge to capture even a small percentage of this market. A top-down approach gives you inflated data, and you often can't rely on it to make good decisions.
This is why it's much more effective to use the bottom-up approach. This approach is time-consuming, because you do all of your own market research and you don't rely solely on generalized forecasts and trends. However, you'll get a more realistic and accurate assessment of your market's potential.
This article focuses on how you can use a bottom-up approach to market sizing.
How to Calculate Market Size
Follow the steps below to use this approach.
1. Define Your Target Market
To predict the size of your market, you need to know the type of person that your product or service is best suited to. Your offering has to fulfill a need – or solve a problem – uniquely well for a group of people, and you need to define who these people are.
Also, think about how you can access these customers – there's no point considering them if you can't reach them cost-effectively.
You can use market segmentation to divide your market into specific groups. This gives you a greater understanding of each group that your product or service will appeal to, and it helps you to tailor your offering to the specific needs of that group. Once you've identified the different possible segments in your market, choose the ones that you want to focus on to build your business.
Now you need to determine how large this market is. To start, contact business organizations, data providers, civic organizations, city and state development offices, or regulatory agencies that handle business and commerce; and do what you can to source a list of potential clients in your chosen segments.
Your organization wants to develop point-of-sale software for mid-sized grocery stores. But, before you invest the time and money to develop the software, you need to make sure that the market is large enough, and that people are interested enough in your product to buy it.
After researching online and contacting your region's business and commerce department, you determine that there are roughly 10,000 mid-sized grocery stores in your country, and you source a list of these stores.
2. Use Market Research to Assess Interest in Your Product
Obviously, not everyone in your target market will want to buy your type of product. So your next step is to estimate realistic interest.
One way to do this is to focus on competitors who target the same group of buyers. What is their market share? And what are their annual sales for similar products or services?
If your competitors are exclusively focused on this market, this can give you a good estimate of potential market size. However, it can be almost impossible to source this information if they focus on other markets as well, or if they are part of larger business groups.
Another way to assess interest is through individual interviews, focus groups, and surveys. Question a sufficiently large sample of people or businesses that fall within your target market, and explain what you have to offer. The larger your sample, the better your analysis will be. Does this product interest them? What would they feel comfortable paying for it? And how likely are they to purchase your product or a similar product within the next two years?
It's important to draw conservative conclusions based on the feedback you get from these focus groups or surveys. Often, people will say one thing and do another. In particular, people often "think twice" before actually making a purchase; and this is especially true as budgets, interests, and market conditions change.
Over the course of three months, you talk to 100 randomly selected mid-sized grocery stores, which represent one percent of your target market. You explain the idea behind the new software, and the benefits it will provide to the store owners.
After the presentations are finished, 35 stores express a strong interest in the software, and a willingness to buy once it's available. To be conservative, you reduce this number to 18. So, 18 percent of stores in your market will be interested in this product. Out of 10,000 possible grocery stores, this means that 1,800 could buy.
It will obviously take a lot of time to set up and conduct this research. Think carefully about any other market research information you might need, and, where appropriate, gather this at the same time.
Step 3: Calculate Potential Sales
You now have a more realistic figure that represents how popular your product or service could be to your target market. Use this data to decide whether your product is worth the investment and risk.
To do this, develop a financial model of your business using the data you have gathered (see our articles on Cash Flow Forecasting and use of NPVs and IRRs for more on this.) Then, identify key assumptions within your model, and test these using techniques such as Scenario Analysis and Monte Carlo Analysis.
You've determined that 1,800 grocery stores might invest in your software, which costs US$30,000. If 100 percent of these stores purchase the software, this is a return of US$54 million.
Your organization has already estimated that it will have to invest at least US$7 million to develop, test, and market the new software. This investment is only 13 percent of potential annual revenues, so the risk is low, even if the response isn't as positive as predicted. Your organization therefore decides to move forward with the development of new software.
Your "market size" is the total number of likely buyers of your product or service within a given market.
To calculate market size, you need to understand your target customer. Assess interest in your product by looking at competitor sales and market share, and through individual interviews, focus groups or surveys. Your goal is to determine how many people within your target market are likely to purchase your product.
Last, use this information to decide whether the investment is worth the risk, investment and hard work associated with building the business.
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