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A Generalized Framework for Estimating Customer Lifetime Value When Customer Lifetimes Are Not Observed

Siddharth S. Singh, Sharad Borle, and Dipak C. Jain*

Authors are listed in random order. Siddharth S. Singh is an Assistant Professor of Management, Jesse H. Jones Graduate School of Management, Rice University, Houston, TX 77005; Sharad Borle is an Assistant Professor of Management, Jesse H. Jones Graduate School of Management, Rice University, Houston, TX 77005; and Dipak C. Jain is the Dean of J. L. Kellogg School of Management, Northwestern University, Evanston, IL 60208.

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Electronic copy available at: http://ssrn.com/abstract=1154709

A Generalized Framework for Estimating Customer Lifetime Value When Customer Lifetimes Are Not Observed

Abstract
Measuring customer lifetime value (CLV) in contexts where customer defections are not observed, i.e. noncontractual contexts, has been very challenging for firms. This paper proposes a flexible Generalized Simulation-based estimation Framework (GSF) for predicting lifetimes and measuring customer lifetime value (CLV) in such contexts. In the literature, two existing state-of-the-art models for lifetime value calculations in a noncontractual context are the Pareto/NBD and the BG/NBD models. Both the Pareto/NBD and the BG/NBD models are based on fixed underlying assumptions about drivers of CLV that cannot be changed even in situations where the firm believes that these assumptions are violated. The proposed GSF (not being a model per se, but a flexible estimation framework) allows the user to use any of the commonly available statistical distributions for the drivers of CLV, and thus the multitude of models that can be estimated using the GSF (the Pareto/NBD and the BG/NBD models included) is limited only by the availability of statistical distributions. This flexibility is demonstrated in an empirical application where three additional models (in addition to the Pareto/NBD and BG/NBD) are estimated and a comparative predictive performance (in predicting customer lifetimes and CLV) of all the five models carried out. Further the GSF is used to estimate a sixth CLV model with covariates and correlations across the drivers of CLV. Thus potential users of the Pareto/NBD and BG/NBD models now have a flexible framework which allows them to estimate a multitude of models (in addition to these two models). In addition, the GSF allows users to incorporate covariates and correlations across outcomes in assessing lifetime values of their customers. Key Words: Customer Lifetime Value; Pareto/NBD; BG/NBD; Forecasting; Simulation; Data Augmentation; MCMC methods.

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Electronic copy available at: http://ssrn.com/abstract=1154709

1. Introduction
In customer relationship management, firms focus on long-term relationship with customers in order to increase profitability. In managing customer relationships over time, firms have to make various decisions concerning which prospects to acquire, which customers to retain, how much to spend in acquiring and retaining a customer and who to target for promotions. To plan these actions and measure their success, firms commonly use Customer Lifetime Value (CLV) as a metric.1 Therefore, estimate of CLV directly impacts both the quality of these decisions and their evaluation of success. Given the critical importance of CLV, various methods to measure CLV or its drivers have been proposed in different contexts of the customer-firm relationship. These methods range from a hazard rate model used in contexts where customer defections of completed customer lifetimes are observed (Bolton, 1998; Bhattacharya, 1998) to the Pareto/NBD model (Schmittlein, Morrison, and Colombo, 1987; Schmittlein and Peterson, 1994) and the BG/NBD model (Fader, Hardie, and Lee, 2005) in contexts where customer defections are not observed. Of all the contexts studied, measuring CLV is most challenging in a noncontractual context. A non-contractual context is one where the firm does not observe customer defection and the relationship between customer purchase behavior and customer lifetime is not certain (Fader et al. 2005; Schmittlein et al. 1994; Reinartz and Kumar 2000, 2003). This is also the most common context in practice. Examples of noncontractual context are retail purchases and catalogue purchases where the firm does not know whether a customer has defected or not. To measure CLV in noncontractual contexts, one needs to first forecast the drivers of CLV, i.e. customer lifetime and purchases. Two widely recognized state-of-the-art models for this purpose are the extended Pareto/NBD (Schmittlein et al 1987, 1994) and the BG/NBD model (Fader et al 2005), where the latter is a modification of the Pareto/NBD model. Since this paper also focuses on a noncontractual context, we discuss these two models in detail now.

Customer Lifetime Value (CLV) is defined as the net of the revenues obtained from a customer over the lifetime of transactions minus the cost of attracting, selling, and servicing the customer, considering the time value of money (Berger and Nasr, 1998).

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. 2005. 1994. Borle. Singh and Jain forthcoming). Schmittlein et al. 3 The estimation involves multiple evaluations of the Gauss Hypergeometric Function which in turn may be a source of computational difficulty (Fader et al 2005). The BG/NBD model (Fader et al 2005) was developed as an alternative to the Pareto/NBD model because of the computation difficulties in estimating the Pareto/NBD3. 1994.. to our knowledge only a few studies so far have empirically validated this model (Fader et al. the primary challenge in measuring CLV2 lies in estimating the lifetime of a customer or the probability of a customer being alive (i. The Pareto/NBD model assumes that customer lifetimes across the population are distributed per a Pareto distribution (Schmittlein et al. along with an estimate of future customer spending has been used by researchers to estimate CLV (e. The Pareto/NBD model is an elegant way of estimating the probability that a customer is alive at any time. a function for the probability of a customer being alive at any time is obtained and subsequently an estimate of CLV is obtained (see Schmittlein et al. While the first study finds that the model forecasts future purchasing accurately. for more details). The model assumes independence of the drivers of CLV (interpurchase times and purchase amounts). Although this model was proposed many years back. Using these assumptions. Reinartz et al. there can be a time lag between the last purchase and defection). researchers have generally considered the revenue stream from a customer to estimate the lifetime value of the customer while ignoring the costs of servicing the customer. 2000).e. In the BG/NBD model the number of purchases that a customer makes during her lifetime are assumed to be distributed across the population per a Beta-Geometric (shifted) distribution and customers are assumed to defect (when they defect) immediately after purchasing unlike the Pareto/NBD model that assumes customers can defect at any time (i. the second study uses data where defections are observed and finds that the model forecasts poorly.g. The parameter of the individual customer level exponential interpurchase time is distributed across the population per a Gamma distribution. 2 4 .. 1987. The assumptions on the In the CLV literature. still being in business with the firm) at any time.In a noncontractual context. The extended Pareto/NBD model (Schmittlein et al.e. 1994) further assumes that the purchase amounts are distributed per a Normal distribution. This information. We too take this approach in this paper. 1987) and interpurchase times at the individual customer level follow an exponential distribution.

comes with a price.. however. Extant research has found that the risk of purchase can vary with time (e. Jain and Vilcassim. For example. The forecasting performance of the BG/NBD model is also similar to the Pareto/NBD model (Fader et al. both the models also assume that customer interpurchase times and purchase amounts are independent of each other.g. in cases where the underlying latent customer lifetime does not confirm to the distributional assumptions in these models. 1991). we develop and apply a flexible. generalized simulation-based framework for estimating CLV in a noncontractual context. both models assume an exponential interpurchase time distribution for each customer. we can never say with certainty which distribution is more appropriate for customer lifetime. and measuring CLV in these contexts is challenging because the firm never observes the defection of any of its customers (past or present) and hence a probabilistic assessment of the defection process has to be made. It uses data augmentation techniques (Tanner and Wong. (forthcoming) in their empirical application show that the Pareto/NBD model does not predict well when the drivers of CLV are not independent and when customer lifetimes do not follow a Pareto distribution. In this paper. Borle et al. They make assumptions that might be restrictive in many situations. For example. Also. The attractiveness of both the Pareto/NBD and the BG/NBD models lies in using commonly available customer-level information with firms (i. their performance is likely to suffer. which is a challenging task given that the firm does not know when a customer defects. It is clear that noncontractual contexts are very important in practice. This means that the risk of purchase for a customer remains constant.interpurchase times in the BG/NBD model are exactly the same as in the Pareto/NBD model. The elegance of these two models. and that make better predictions of the drivers of CLV thus leading to better estimates of CLV.e. Extant research suggests that this assumption also might be violated in many situations. recency and frequency of purchase) to estimate future customer purchase behavior. there is a need to develop flexible methods that are easy to implement. Therefore. 2005). Since by definition customer lifetimes are not observed in a noncontractual context. 5 . with the purchase parameter distributed as Gamma across the population. Finally.

It is a flexible Markov Chain Monte Carlo (MCMC) framework that uses data augmentation and generalizes the existing models.g. We refer to this framework as the GSF (Generalized Simulation Framework). three other models (the Gamma/NBD.1987. the GSF can easily incorporate covariates and correlations in the drivers of CLV. interpurchase time and customer spending to estimate CLV. In our empirical application. 2. the Pareto/NBD and the BG/NBD. to estimate unobserved customer lifetime and CLV. The flexibility is further demonstrated by using GSF to estimate a CLV model incorporating covariates and correlations across drivers of CLV. It can incorporate any reasonable distribution(s) for customer lifetime. rather it is an estimation framework that allows many models to be estimated. apart from the Pareto/NBD and BG/NBD models. The key features of the proposed framework are as follows: 1. It is important to note that the proposed GSF is not a model. Thus the GSF addresses the need for flexibility in modeling and estimation of customer purchase behavior and CLV in a noncontractual context. to measure CLV. Further. in addition to the Pareto/NBD and the BG/NBD models. This flexibility in itself is a significant step forward in implementing models for Customer lifetime value prediction when lifetimes are not observed. e. other more flexible models (e. We apply the framework on data from a direct marketing company.g. The predictions of the drivers of CLV and subsequently the CLV estimates using these models are then compared. Incorporating covariates and correlations further improves these predictions. to be described later) can be estimated using the GSF. we find that more flexible distributional assumptions than the ones made in the Pareto/NBD and BG/NBD models lead to significantly better predictions of customer lifetime value. 2001). the CMP/NBD and the Gamma/Gamma models) using this framework. the Gamma/Gamma model. 3. We demonstrate the flexibility of the GSF by estimating. 2. The Generalized Simulation-based Framework (GSF) 6 . The estimation procedure being simulation-based circumvents the necessity of ‘computationally difficult’ likelihood calculations as in the estimation of Pareto/NBD model using existing approaches. Therefore. van Dyk and Meng.

it can choose a more flexible distribution such as a Gamma distribution for customer lifetimes. Once again. the literature does not offer other equally good or better alternatives for the purpose. Such an approach allows any reasonable distributional assumption to be modeled and estimated. which is to probabilistically assess customer defection conditioned on observed purchase history. In practice. The GSF framework approaches the problem in a different manner. Rather than start with fixed assumptions about the distribution of customer lifetime and interpurchase time irrespective of the true nature of these. In existing approaches to measuring CLV in the noncontractual context.As its name suggests. if a firm believes that the unobserved customer lifetimes are unlikely to have a Pareto distribution across the population (and thus the Pareto/NBD might not be a good choice). rather. the assumptions underlying the model might not hold. it is an estimation framework which allows the user to propose and estimate a multitude of CLV models with 7 . it is important to point out that the GSF is not a CLV model per se. Also. These models are then estimated using past customer purchase data (example. Unlike the traditional approaches of the Pareto/NBD and the BG/NBD models. One important issue in applying these models is the lack of flexibility with respect to these assumptions. and use these assumptions to arrive at an expression for customer defection model and the customer spending model. For example. the GSF is a simulation-based framework to estimate models of future customer purchase behavior which can subsequently then be used to predict Customer lifetime Value in a noncontractual context. the framework focuses on the estimation procedure itself. However. the Pareto/NBD and the BG/NBD models). In such a situation where the firm or the researcher believes that the assumptions are violated. interpurchase times and purchase amounts. a common approach is to impose distributional assumptions on customer lifetime. Similarly it can choose a flexible distribution for interpurchase times and purchase amounts. nothing can be done to adjust the model for this variation. this is not a constraint in this framework as the framework uses simulation to estimate the parameters of the assumed customer lifetime and interpurchase time distributions for each customer. the framework may or may not (based on the distributional assumptions) lead to one closed form expression for the model likelihood.

So. we explain it using the BG/NBD model as another example. 2001) which is explained below using the Pareto/NBD model as a specific example. Under one paradigm. The time from the initial purchase occasion until the last observed purchase occasion for 8 . So. the two prominent paradigms are in terms of how defection or the ‘death process’ (which is unobserved) is modeled. and further. the death process is modeled in terms of the time elapsed since the initial purchase (for example. the BG/NBD model). The heart of the proposed GSF is a data augmentation algorithm (Tanner et al. van Dyk et al. 1987. these are but two of the many models than be estimated using the GSF.varying distributional assumptions on the drivers of CLV. The incorporation of covariates and correlations is discussed later in Section 5 when we further extend the GSF. both these paradigms are unified and easily implemented using the GSF framework. Table 1a presents the notation used in the framework. Because of the flexibility of the GSF we can now propose and estimate a variety of new CLV models as we demonstrate in this paper. While the other paradigm models the death process in terms of number of lifetime purchases (example. The total time for a customer h from the initial purchase occasion until the current time. the Pareto/NBD model). it should be viewed as an approach generalizing these models and adding flexibility in proposing and estimating a variety of CLV models which hitherto were not possible. allowing the users to incorporate covariates and correlations in the drivers of CLV. the GSF can also be used to estimate the Pareto/NBD and the BG/NBD models. As we will demonstrate. In the current literature dealing with models of customer lifetime value in non-contractual contexts. Table 1a: Notation used in the GSF framework (using Pareto/NBD assumptions) Notation h Th th Explanation A particular customer. rather than viewing the GSF framework as a competitor to the existing CLV models. In the Supplemental Note.

2) Assume a distribution for the interpurchase times for a customer s +1 (1) Again. totLIFEh ~ Pareto(s. i. any reasonable commonly available distribution can be used. customer lifetimes are distributed as. IPThi ~ Exponential(λh) f (IPThi | λh ) = λh e − λh IPThi (2) where IPThi is the interpurchase time between the ith and the (i-1)th purchase for customer h with the exponential parameter λh distributed per a Gamma distribution across the population. Therefore. since we have chosen the Pareto/NBD model as an example.β) ⎞ s⎛ β f (totLIFEh | s. we assume that the individual level interpurchase times are distributed exponential. λh ~ Gamma(r. This is a latent variable. β ) = ⎜ ⎟ ⎜ β + totLIFE ⎟ β⎝ h ⎠ where totLIFEh is the unobserved total lifetime for customer h. Xh IPThi totLIFEh totLIFEh(old) and totLIFEh(new) The total number of purchases made by customer h since the initial purchase in time period Th. The interpurchase time between the ith and the (i-1)th purchase for customer h. Schmittlein et al 1987). Intermediate variables used in the simulation of the latent variable totLIFEh The specific steps in the framework are as follows: 1) Assume a distribution for the unobserved customer lifetime across the population As mentioned earlier. with the latest purchase being at time th. This distribution could be chosen based on assumptions regarding the underlying consumer behavior. Total lifetime of customer h from the initial purchase occasion until the customer defects. unobserved by the firm. Since we have chosen the Pareto/NBD model as an example we use the Pareto distribution (of the second kind.α) 9 .e.customer h (Therefore th ≤ Th).

m. α ) = α r λr −1e − λ α h h Γ(r ) (3) This leads to the number of purchases by a customer in one time unit to follow a Negative Binomial distribution as (Purchases in unit time)h ~ NBD(r. α ) = Γ(r )x! ⎜ α + Th ⎟ ⎠ ⎝ r ⎛ Th ⎞ ⎜ ⎟ ⎜α +T ⎟ h ⎠ ⎝ x (4) As mentioned earlier. for this illustration we follow the same assumptions as the Pareto/NBD model. s and β using simulation/data augmentation Table 1b presents a step-by-step description of the simulation/data augmentation algorithm: Table 1b: Simulation/data augmentation Steps for the proposed GSF (using Pareto/NBD assumptions) Simulation Step Step 0 Initialization Description Initialize: totLIFEh = Th (or any number ≥ th). Γ(r + x ) ⎛ α ⎞ ⎟ ⎜ P( X h = x | r .f (λh | r .α) So the p. 3) Estimate the parameters r. 10 . α.f. for purchases by customer h in Th time is given by.

β) Step 5 Step 6 Set totLIFEh(old) = totLIFEh Go to Step 1 The simulation begins with an initialization step (Step 0) that initializes various parameters to be estimated (r. Similarly the likelihood (likeh(old) ) of the interpurchase time data for each customer h conditioning on the lifetime being equal to totLIFEh(old) is also 11 . and totLIFEh(old) & totLIFEh(new) which are intermediate variables used to simulate totLIFEh. s and β). and likeh(new) is the likelihood of the interpurchase time data for customer h conditional on the lifetime of h being totLIFEh(new) drawn in the previous step. update NBD parameters (r.Initialize: totLIFEh(old) = totLIFEh(new) = totLIFEh Initialize: The parameters (r.β) and the NBD distribution parameters (r. Step 2 calculates the likelihood (likeh(new) ) of the interpurchase time data for each customer h conditioning on the lifetime being equal to totLIFEh(new).β) Step 1 Draw totLIFEh(new) (such that totLIFEh(new) ≥ th) from the Pareto distribution with the current parameters (s. ( ( likehnew) + likehold ) Assign totLIFEh = totLIFEh(new) with probability probh = else assign totLIFEh = totLIFEh(old) Step 4 Estimate the Pareto distribution parameters (s.…N.α) and Pareto parameters (s.α) and (s. Step 3 ( likehnew) . The next two steps (Steps 2 &3) are used to either accept this candidate lifetime or not accept it. α. and also initializes the latent variables used in the simulation namely totLIFEh (which is the unobserved total lifetime of customer h).β) Step 2 Calculate two likelihoods for each customer—likeh(old) is the likelihood of the interpurchase time data for customer h conditional on the lifetime of h being totLIFEh(old).2. The next step (Step 1) draws a candidate total lifetime (totLIFEh(new)) for every customer h = 1.α) conditioning on the total lifetime of the customer h being totLIFEh. That is.

Note that the GSF naturally estimates P(alive | Xh. for a particular customer h. L r . α | X h . α )dλ h h = ( Γ(r )Γ α + totLIFEhnew) ( Γ(r + X h )α r ) r+ Xh (5) On the other hand. Step 4 then conditions on the total lifetime of customer h being equal to totLIFEh and estimates (gets an update) for all the parameters (r. 12 . β). th. Another natural outcome of the GSF is the expected lifetime for each customer. = Γ(r + X h )α r r+ X Γ(r )Γ(α + Th ) h (6) Step 3 accepts the drawn totLIFEh(new) with probability probh = ( likehnew) . else it sets totLIFEh =totLIFEh(old)..calculated. Th) which is the probability that a customer h with purchase history (Xh. We use MCMC methods to implement the GSF. That is. for example. The simulation is repeated and convergence of estimates monitored. So. th. Step 5 simply sets up information for the next iteration and the entire simulation is repeated. if the totLIFEh(new) is greater than or equal to Th then the likelihood likeh(new) is equal to. Post convergence one may take a set of draws to make posterior inferences on various parameters. Note that conditioning on totLIFEh makes the estimation (updating) of these parameters easy as one does not need to evaluate the full (complicated) likelihood of the Pareto/NBD model (Schmittlein et al 1987. Th . t h . It is simply the percentage of draws of totLIFEh greater than Th in the simulation output.λh e h h2 − λh IPThX h e −λh (totLIFEh ( new ) −t h ) f (λ | r . if the totLIFEh(new) is less than Th then the likelihood likeh(new) is equal to. it ( ( likehnew) + likehold ) sets totLIFEh =totLIFEh(new) with probability probh (for each customer). Fader and Hardie 2005). α. Th) is “alive” at time Th. s. totLIFE ( ( new ) h )= ∫ λ e h 0 ∞ − λh IPTh1 λh e −λ IPT . It simply is the average of the totLIFEh draws in the simulation output..

2 AMNThi ~ Normal θ h . σ W ). 2 θ h ~ Normal (E[θ ]. The purchase amount spent by household h at purchase occasion i is given by AMNThi.We used the Pareto/NBD model assumptions to illustrate the GSF. Estimating Customer Lifetime Value To estimate customer lifetime value. 1994). 3. Again. 3. we can use simulations to estimate the unobserved lifetime and the lifetime value of each customer (CLV) by 13 . however. σ A ). σ A ) (8) This is a standard ‘Normal’ sub-model for purchase amounts as used in the ‘Extended Pareto/NBD model’ (Schmittlein and Peterson. using the GSF framework we can use many ways to model purchase amounts. interpurchase time and purchase amount sub-models.2 Estimation of Customer Lifetime Value Using the customer lifetime. Later in Section 5 we further extend the purchase amount sub-model by using a Gamma distribution and allowing correlations across the purchase amounts and interpurhase times. σ W ( ) (7) Further. apart from the defection process and interpurchase times we also need to model the purchase amounts. the flexibility of the framework allows one to use any distribution for the defection process and any distribution for the interpurchase times and purchase amounts thus giving the user a great amount of flexibility in modeling the drivers of CLV and subsequently estimating lifetime values of customers. This 2 variable is assumed to follow a normal distribution with parameters (mean and variance) ( θ h . Here we lay out an independent Normal sub-model for purchase amounts [the same as used in Schmittlein and Peterson (1994)]. θh is heterogeneously distributed in the population per a normal distribution with 2 parameters ( E[θ ].

IPThi (i = 1. t h = Xh ∑ IPT i hi The total number of purchases made by customer h since the initial purchase in time period Th. estimates of total Lifetime (or total Lifetime purchases) for every customer is a natural outcome of the output simulations when we use the GSF for model estimation. The interpurchase time between the ith and the (i-1)th purchase for customer h. The time from the initial purchase occasion until the last observed purchase occasion for customer h (th ≤ Th). IPThi ~ Exponential(λh) (9) (10) λh ~ Gamma(r+Xh . The purchase amount spent by household h at purchase occasion i. s and β. with the latest purchase being at time th.….discounting all the future cash flows from each customer (until the customer is expected to defect) to the current time. Further. Using these estimates we then simulate a stream of interpurchase times for every customer h using the estimated interpurchase time distribution.α+Th) 14 . having observed the customer purchase behavior since her initial purchase a firm wishes to predict the lifetime and lifetime value (remaining lifetime value) of that customer. α.Xh) and th is given as follows (conditional on total lifetime totLIFEh being greater than Th). if one were to assume a Pareto/NBD model for purchase behavior with parameters r. Th IPThi th The total time (for a customer h) from the initial purchase occasion until the current time. Xh. For example.2. What does the firm observe: The firm observes the following characteristics of the purchase process by customer h. AMNThi Using GSF. This process is explained below: The objective: at the current time. we can estimate the parameters of the particular CLV model. then the updated interpurchase time distribution for customer h with observed purchase history Th. As mentioned earlier.

3. such that the sum of all these drawn interpurchase times is less than (totLIFEh –th). Further. the interpurchase times and purchase amounts substantively increases the models available to a firm to assess lifetime values of its customers. estimation of the Pareto/NBD model requires repeated evaluation of the Gauss Hyper geometric function which itself is an infinite sum series. 2 AMNThi ~ Normal θ h .3 Flexibility of the GSF As mentioned earlier.i = X h +1 is drawn such that IPTh . Using existing approaches. IPTh . i = X h + 1. An Exponential(λh) distribution is used to draw the interpurchase times.i = X h +1 > Th − t h 4 This is a natural outcome when we use the GSF for model estimation. one needs to draw a realization of λh from a Gamma(r+Xh . σ W ( ) ⎞ ⎟ ⎟ ⎟ ⎟ ⎠ (11) ⎛ 2 Xh 2 ⎜ σ A ∑ AMNThi + σ W E [θ ] 2 2 σ Aσ W .α+Th) distribution and then draw a string of interpurchase times IPThi .. the estimation procedure does not need to evaluate ‘complicated’ likelihood functions as is the case with the Pareto/NBD model estimated using traditional approaches6. (Schmittlein and Peterson. The very first simulated interpurchase time for customer h.. This process of simulating interpurchase times and purchase amounts and then discounting them to current time is done for all the simulated draws of totLIFEh (Table 1a )5. θ h ~ Normal ⎜ i =1 2 2 2 2 ⎜ X hσ A + σ W X hσ A + σ W ⎜ ⎝ (12) These simulated amounts are then discounted back to current time to get an estimate of the CLV. 6 5 15 . X h + 2. 1994).So. The expected CLV per customer is then simply an average of these simulations. 4 Along with these simulated interpurchase times we also simulate the purchase amounts using the customer spending sub-model (equations 7 and 8) where future amount per reorder is simulated from an updated distribution for purchase amounts for customer h as follows. the flexibility of the proposed GSF in incorporating any distributional assumption on the defection process..

1 Data The data comes from a direct marketing membership-based company. Therefore. in this data customer defections are observed unlike in a noncontractual context where such defections are not observed. The company keeps track of all customer purchases until the membership is terminated by the customer. We then go on to propose and estimate three more models using different assumptions for the defection process and the interpurchase times. The use of this data allows us to compare alternative methods to measuring CLV (Customer Lifetime Value) with the actual CLV. These are also estimated using the traditional approach (of using the overall model likelihood to estimate various parameters) and the resulting estimates compared to establish face validity of the GSF. Empirical Application This section first describes the data used in this study and then uses the GSF (Generalized Simulation-based Framework) to estimate the Pareto/NBD and the BG/NBD models. The data consists of customers who joined the firm’s membership in a year in late 1990s. Gamma/NBD and the Gamma/Gamma models. 16 . 4. details of which are given later in the text. We conclude the empirical application by using all the estimated models (a total of five models) to predict customer lifetimes and customer lifetime values and then evaluate the relative model performances. These different assumptions lead to the CMP/NBD. Later in Section 5 of the manuscript we further demonstrate the flexibility of the GSF by incorporating covariates and correlations across drivers of customer lifetime value and using yet another distribution for the purchase amount.In our empirical application section (the next section) we demonstrate this flexibility by estimating five example lifetime value models (including the Pareto/NBD and BG/NBD) and then comparing their relative performance in predicting customer lifetime value and customer lifetimes. 4.

This approach allows us to apply different models on the data. we also behave as if the company does not know whether any customer has defected or not. Xh. They consider the past purchase behavior of customers until the current time to predict future purchase behavior. 1999. compare them.8 Therefore. Most firms when using models to predict CLV in a noncontractual context make predictions at a specific date (current time). Keeping with the spirit of the methods to measure CLV as used in practice. firms do not observe customer defection.The time of each customer’s purchase events are recorded from the day they join the membership until they terminate it. we slice our data at January 01. The later purchase events are indexed with increments of one. the time in months since the initial purchase till the ‘slice’ date (January 1. The variables observed by the firm for each customer are IPThi. the time in months since the initial purchase till the last observed purchase of household h. AMNThi. defect7. behaving as if the company wishes to estimate the lifetimes and lifetime values of it’s customers on January 01. The resulting data fulfills all the characteristics of data on which CLV models in a non-contractual setting can be applied most appropriately. we only consider customer purchases starting from the initial purchase and ignore the time of joining the membership and the time of terminating it. and use this prediction to estimate lifetime value of each customer. and evaluate their performance. 17 . 1999. 1999. Th. i. The choice of January 1. we behave as if we do not know the lifetime of the customer. th. A random sample of 5000 customers is then chosen from this data set to execute our empirical analysis. 7 8 We observe defection for all the customers in our dataset. the purchase amount (dollar used as the general currency) across each of these purchase occasions. the total number of purchases (purchase occasions) for customer h. Further. We refer to the initial purchase as the 0th purchase. In noncontractual contexts. Therefore. the interpurchase time for household h between the ith and (i-1)th purchase (in months). and only observe purchase behavior starting from an initial purchase by the customer.e. To make our data comparable to data in a noncontractual context. 1999 is for illustration and is not based on any particular reasoning. we behave as if all that the company knows about its customers is their purchases prior to January 1.

9 18 .0 18.76 10.61 0. Table 2 presents summary statistics (across all customers and all purchase occasions) on all these key variables in the data. Table 2: Summary Statistics Mean Std Dev Minimum* Maximum initial purchase. In Table 3 below we present the estimates of the four parameters of this model.1 The Pareto/NBD Model The details of this model have already been discussed earlier in the text.13 5. the full conditional distributions and the MCMC steps are included in the Supplemental Note. Table 3: The Pareto/NBD Model Estimatesa The details of the estimation including the set of prior distributions used. The model is estimated using the proposed GSF and also using the traditional approach of taking the full model likelihood and doing a Bayesian inference after assigning appropriate diffuse priors for all model parameters9.92 * The zeros in the data correspond to a situation where the customer was never observed making another purchase since the We now apply the GSF to estimate five different customer lifetime value models.1999).07 0 27 th (months) 9. The full model likelihood has been derived in Fader and Hardie (2005) and we use that likelihood for a traditional estimation of the Pareto/NBD model.25 0. 4.0 23.01 0.64 AMNThi ($) 16.2 Model Estimates 4.30 3. IPThi (months) 1.79 Xh 4.0 179.39 Th (months) 16.98 0.91 1.49 23.2.75 3.

163 (8.Parameters Estimates Using the GSF Framework Using a Traditional Approach 32.09 (23.2762) 9. The full model likelihood has been derived in Fader. Table 4: The BG/NBD Model Estimatesa 10 However. Please see Fader et al.4380) 78.99 (8.496 (1. The assumptions on the interpurchase times are exactly the same as those made in the Pareto/NBD model.2. 4.2004) 185. 19 . this does not imply that the NBD parameters across the two models will be the same.2 The BG/NBD Model In this model. 2005 for details.10 IPThi ~ Exponential (λh) (13) (14) (15) λh ~ Gamma (r.242 (3. This model too is estimated using the GSF and the traditional approach of taking the full model likelihood and doing a Bayesian inference.7886) r 32.1587) 185.509 (1.6397) α s β a The numbers in parenthesis are the posterior standard deviations The two approaches lead to similar estimates and statistical tests carried out to assess differences in parameter estimates across the two approaches fail to detect any differences.3399) 9. the number of purchases in a lifetime of a customer is assumed to be distributed across the population per a Beta-Geometric (shifted) distribution. Hardie and Lee (2005) and we use that likelihood for a traditional estimation of the BG/NBD model.4184) 78. The results are given in Table 4.69 (22.583 (3. α) totPURh ~ Shifted-Beta-Geometric (a. b) where IPThi is the interpurchase time for customer h between the ith and the (i-1)th purchase and totPURh is the total number of purchases made by customer h during her lifetime (this variable is unobserved by the firm).

IPThi ~ Exponential(λh) λh ~ Gamma(r. The details of these three models are presented in Table 5.060 (2. Using the GSF we estimate three models using different underlying assumptions on the defection process and the interpurchase times.n) distribution. 4. totLIFEh ~ Gamma(m.3217) 105.449 (1.α) across the population.3 Flexibility of the GSF Framework We now begin to demonstrate the flexibility of the GSF.α) across the population. Table 5: Flexibility of the GSF Framework Assumptions Model CMP/NBD Interpurchase time Individual interpurchase time distributed Exponential(λh).α) The interpurchase times distributed Gamma(r.n) distribution. totLIFEh ~ Gamma(m.0115) r 9. Later in Section 5 we further demonstrate this flexibility by incorporating covariates and correlations in the model and also allowing a different distribution for the purchase amounts.2.655 (0.α) Gamma/NBD IPThi ~ Exponential(λh) The lifetime distributed across the population per a Gamma(m.4822) 15. totPURh ~ CMP(m.6627) 21. IPThi ~ Gamma(r. the two approaches leads to similar parameter estimates.4022) α a b a The numbers in parenthesis are the posterior standard deviations Again.4257) 110.α) across the population. The exponential parameter λh distributed Gamma(r.53 (17.567 (1.4298) 15.n) Individual interpurchase time distributed Exponential(λh). Defection Process Number of lifetime purchases distributed across the population per a Shifted ComPoisson(m. The exponential parameter λh distributed Gamma(r.n) λh ~ Gamma(r.Parameters Estimates Using the GSF Framework Using a Traditional Approach 9.14 (16.α) Gamma/Gamma 20 .713 (0.n) distribution.6305) 21.790 (2.n) The lifetime distributed across the population per a Gamma(m.

The distributions we use for illustration are the Exponential. forthcoming). Kadane. Further.7193) and within customer 2 variance is 83.058. As demonstrated in the previous section (and as will be further demonstrated in Section 5).825 with a posterior standard deviation of 0. Singh and Westbrook.3 Predictive Performance In this section we present the predictive performance of various models estimated using the GSF framework. Boatwright. Borle. 21 . though later in Section 5 we do demonstrate an application of the GSF using a different purchase amount sub-model. The variance of purchase amounts across 2 customers is 19. The estimated parameters indicate that the average spending by a customer is 16. BG/NBD models).17 ( σ A = 19. the GSF subsumes popular CLV models existing in the literature (the Pareto/NBM. with a posterior standard deviation of 0.0937). Kadane 2003.Table 5 illustrates the flexibility of the GSF using a few examples. Borle.06 ( σ W = 83. the Gamma and the Conway Maxwell Poisson.83 $ (E[θ] =16.8622) 4. 11 The estimates from these three models are provided in the Supplemental Note. the GSF is not a model per se but a flexible estimation framework using which CLV models can be proposed and estimated.4 Customer Spending sub-model We use the same purchase amount sub-model as used in the extension of the Pareto NBD model due to Schmittlein et al.172.11 4.2. Dholakia. As mentioned earlier. It is a generalization of the Poisson distribution and has a distinct advantage over other count distributions in its ability to model under dispersed as well as over dispersed data. (1994) [equations 7 and 8]. with a posterior standard deviation of 0. Borle. the GSF can be used to propose and estimate many ‘new’ models for measuring lifetime value. The Exponential and the Gamma distributions are popular distributions and have found many applications in the marketing literature. Nunes & Shmueli 2005. The Conway Maxwell Poisson is a count distribution and has recently been applied in the marketing literature (Boatwright.

for every customer in the sample we predict the three key drivers of lifetime value viz. 4 & 5) and the parameters of the customer spending model. however the relative performance of the models considered does not change. if at all. the purchase amounts and the remaining lifetime (total time since the slice date of January 01. Since.2. The CLV and lifetime predictions are done as explained in Section 3. We also compare the predicted lifetimes. the purpose of presenting a comparison of predictive performances across various CLV models estimated using the GSF framework is simply to continue demonstrating the flexibility of the framework. 12 For CLV models that characterize the defection process in terms of number of lifetime purchases (for example the BG/NBD model) this is the remaining number of lifetime purchases. the interpurchase times. in this particular application of the GSF we are in a unique situation wherein we do know the total lifetime and purchases of every customer (though we behave as if we do not know it in estimating various models) we can calculate the actual lifetime value (Net Present Value or NPV) of every customer on January 01. This predicted lifetime value is compared with the actual lifetime value. 1999 till defection)12. That one model performs better than the other is not a comment on the GSF. The actual customer Lifetime and actual CLV is then used to evaluate the customer lifetime and CLV predictions from various models. The mean absolute deviation (MAD) statistics are used to evaluate the various predictions. 22 . Table 6 provides the results of these comparisons. interpurchase times and purchase amounts with their actual values past the slice date. These are then used to calculate the lifetime value as on January 01. 1999 using an annual discount rate of 12%13. it is a comment on the flexibility that the firm has in the sense that it can propose and estimate a variety of CLV models based on its own assessment of the distributional assumptions for the drivers of CLV. Using each of the five estimated lifetime value models (Tables 3. 1999 (the ‘slice’ date). 13 A range of discount rates from 10% to 15% was also used.So.

47 6.55 15.66 1.58 1.05 5.05 5. 23 .81 0. 1999 Remaining Lifetime. Column III is the mean of deviations of the predictions from the actual lifetime values across the 5000 customers. 1999. out of the 5000 customers 3950 had defected before the slice date.06 10.46 32.03 33.15 1.06 5.23 9.69 9.59 4.27 1.18 24.71 107.18 24.06 1.18 139.83 7. 1999 Column I of Table 6 titled “Actual Average CLV ($)” provides the actual average lifetime value of all the 5000 customers as on the slice date of January 01.45 118.69 1.28 12.72 62.15 10. Interpurchase times and Purchase Amounts past the slice date of January 01.64 8.42 35.05 5. As mentioned earlier. For customers who have defected prior to this date the lifetime value is 0.98 1. this also averages over customers who have already defected.06 5.37 11.19 5. Columns IV to XII further breaks down the lifetime value predictions across the three drivers of lifetime value (the lifetime.62 10. it is a metric that we use for evaluating comparative predictions.18 24.06 1.68 4.06 1.18$ represents an average over lifetime values many of which are 014. The actual average lifetime of 5.18 24.63 8.06 16.05 5.02 5. This is the average of actual lifetime values of the 5000 customers as on the slice date.31 1.69 0.06 1.42 9.39 5. Column II in Table 6 is the average of the predicted lifetime value of each of those 5000 customers using various CLV models for prediction. 14 In our application. interpurchase times and purchase amounts). Column IV provides the average of actual remaining lifetime (as on the slice date) compared to predictions from the five CLV models.90 Lifetime Value as on the slice date of January 01.51 1. thus the number 24.64 1.05 months is the average of remaining lifetimes (on the slice date) across 5000 customers.06 1.65 127.05 10.20 70.87 31.57 1.06 5.Table 6: Model comparisons Model Lifetime Value prediction# (across 5000 customers) I II III Remaining Lifetime* (across 5000 customers) IV V VI Interpurchase times* (across 5000 customers) VII VIII IX Purchase Amounts* (across 5000 customers) X XI XII Actual Predicted Average Average CLV ($) CLV ($) Pareto / NBD BG / NBD CMP / NBD Gamma / NBD Gamma / Gamma # * MAD statistic Actual Average Lifetime* (months) Predicted MAD Actual Predicted MAD Actual Predicted MAD Average statistic Average Average statistic Average Average statistic Lifetime IPT IPT Amount Amount (months) (months) (months) ($) ($) 24.06 5.

06$ is the string of purchase amounts past the slice date. Further Extension of the GSF Framework In this section we further demonstrate the flexibility of the GSF framework by incorporating covariates and correlations in the models estimated using the framework. and then averaged over the set of 5000 customers. In the context of CLV estimation in noncontractual settings. This is then compared with corresponding predictions from various models. the predictions across the models are different. 5.06 months is the string of interpurchase times past the slice date.Columns VII to IX compare the inter-purchase time predictions. The interpurchase times are not predicted in isolation but are predicted conditional on the prediction of lifetime as explained in Section 3. We pick the best predicting model from the earlier section (the Gamma/Gamma model) and further extend it by incorporating covariates and correlations. The main point here is that the GSF approach allows the firm to propose and implement a variety of CLV models using any of the available distributions for drivers of CLV.2. and then averaged over the set of 5000 customers. averaged over every customer. The aim is to demonstrate the ease with which covariates and correlations can be introduced (in CLV model) across drivers of lifetime value. The numbers in next column are the corresponding predictions by various CLV models. The actual average IPT of 1. the best performing model in terms of lifetime value prediction is the Gamma/Gamma model. Given this limited set of five CLV models. the purpose of providing comparative predictive performance across various models is simply to demonstrate the flexibility of the GSF in that it allows such variety of CLV models to be proposed and estimated. As an added demonstration of the GSF 24 . As mentioned earlier. It outperforms the predictions (as compared to other models) across the three drivers of lifetime value and also the lifetime value it self. Finally columns X to XII compare the actual and predicted purchase amounts. averaged over every customer. The actual average amount of 5. Thus although we use the same Gaussian model to model purchase amounts across all the CLV models. Once again the amounts are not predicted in isolation but conditional on lifetime and interpurchase time. to our knowledge such flexibility has not been available to firms before.

IPThi ~ Gamma(rh.α) (17) where IPThi is the interpurchase time between the ith and the (i-1)th purchase for customer h. the lifetime of a customer remains unobserved.flexibility we also extend the purchase amount sub-model by using a different distribution for purchase amounts. the purchase amounts are distributed normal and the unobserved lifetimes are distributed gamma. 16 Males are coded as 0 and females are coded as 1. n) (15) where totLIFEh is the unobserved total life of customer h. 17 The variables ‘Age’ and ‘Salary’ have been estimated from the Block Demographic Trends available for the area of residence of the household. The extended model details are as follows. rh = exp(r0h + r1GENDERh + r2AGEh + r3SALARYh) (18) The individual purchase amounts are also assumed to be distributed Gamma (instead of the Gaussian assumption in the previous section). and (mh. We extend this model by incorporating covariates across all the three drivers of lifetime value and allowing a correlation structure across the interpurchase times and purchase amounts15. age in years and the weekly salary (dollar used as a general unit of currency) for customer h17. Recollect that the firm observes (for every customer) a string of purchase amounts and string of interpurchase times (with the last observed time being censored). 5. AMNThi is the purchase amount on the ith purchase for customer h. rh is further characterized as.1 Model Extension Using the GSF Framework The Gamma/Gamma model from the previous section proposes that interpurchase times across the population are distributed gamma. 15 25 . mh = exp(m0 + m1GENDERh + m2AGEh + m3SALARYh) (16) The variables GENDERh. however. The individual interpurchase times are assumed to be distributed Gamma. n) are the parameters of the Gamma distribution. totLIFEh ~ Gamma(mh. AGEh and SALARYh are the gender16. The unobserved customer lifetimes are distributed per a Gamma distribution. mh is further characterized as.

Σ ) (21) where Ωh = [r0 h . Ωh ~ MVNormal ( Ω.AMNThi ~ Gamma(μh.σ) (19) μh is further characterized as.2 Model Estimates for the Extended Model The extended model in section 5. 18 The details of the estimation including the set of prior distributions used. Ω = [r . the parameters r0 h . μh = exp(μ0h + μ1GENDERh + μ2AGEh + μ3SALARYh) (20) Correlation in the model is introduced by allowing a variance-covariance structure across the interpurchase times and purchase amounts. μ ] and Σ is a 2x2 variance. Further. μ0 h are as specified in equations (18) and (20) respectively. μ0 h ] / .covariance matrix.1 is estimated using the GSF18 and the estimated parameters are presented in Table 7 as follows. Incorporating such a covariance structure allows for dependencies across the interpurchase time and amount and is an efficient use of information in the data. the full conditional distributions and the MCMC steps are included in the Supplemental Note. We introduce a bivariate Normal correlation structure as follows. The off diagonal elements of the Σ / matrix specify the structure of covariance across the interpurchase times and purchase amounts. 5. 26 .

0003 (0.0029) Correlation Structure r1 Interpurchase time r2 r3 0.0011) 0.0013) 0. The shaded cells represent “insignificant” estimates As per estimates in Table 7. As mentioned earlier. The interesting aspect of the estimated correlation structure in Table 7 is that the purchase amounts and inter-purchase times have a positive and significant correlation (the off diagonal elements of the variance-covariance matrix is positive) implying that longer hiatus between purchases is associated with greater spending per occasion.0014) -0. females tend to have a longer lifetime compared to men (m1 is positive and significant). Table 6. these customers tend to spend more per occasion (μ2 is μ3 are both positive).295 (0.044 (0.0013) a The numbers in parenthesis are the posterior standard deviations.0003 (0.0077) -0.450 (0.00009) 0.0003 (0.0001) 0.0733) IPThi IPThi AMNThi AMNThi 1.0085) 0.00007) 0.613 μ = (0. however. In this application we are limited by the availability of covariates. the purpose of this model extension was simply to demonstrate the ease and flexibility of the GSF in that it allows a model to be proposed and estimated that incorporates covariates and correlation across the drivers of CLV. they tend to spend less per occasion (μ1 is negative) and have longer times between purchases (r1 is positive). Next.003 (0.0181) -0.0592) 0. however.0024) 0.029 (0.237 (0.0103) α μ1 Purchase amount Σ Matrix Ω= μ2 μ3 σ r 0. it is trivial to incorporate more covariates (as and when available to the firm) to further refine the model.422 (0. 27 .005 (0. we provide the predictive performance of this extended model on the same lines as provided in Section 4.006 (0.0001 (0.1354) 0.0115) 0.Table 7: The Extended Model Estimatesa Sub-Model Parameter Estimates Sub-Model Parameter Estimates m0 Lifetime m1 m2 m3 n 1.0024) -0.039 (0. Customers with higher ages and higher salaries tend to have lower lifetime (m2 and m3 respectively are both negative).034 (0.005 (0.093 (0.3.0013) 0.817 (0.

1999 As observed in Table 8 the prediction of lifetime value gets better as compared to the best performing model in the previous section [Table 6].87 4.39$ (for the best performing model in Table 6) to 23.05 1. Interpurchase times and Purchase Amounts past the slice date of January 01.98 5. This table is analogous to Table 6 in Section 4. However. the purpose of providing the predictive performance of this extended model is yet again to demonstrate the ease of GSF in proposing and estimating CLV models incorporating covariates and correlations across drivers of lifetime value.23 5. once again. Summary and Discussion Customer lifetime value (CLV) is a metric for evaluating decisions in the context of customer relationship management.3 Predictive Performance of the Extended Model The predictions using this extended model are provided in Table 8. the ability to measure customer lifetime value is critical for successfully implementing and evaluating the success of customer management strategies.39 0.87 3. There are various contexts of customer-firm relationship in practice and firms use different methods to estimate CLV in these contexts. 1999 Remaining Lifetime. The Mean Absolute Deviation in lifetime value prediction improves from 31.58 23. 6.3 Table 8: Model comparisons Model Lifetime Value prediction# (across 5000 customers) I II III Remaining Lifetime* (across 5000 customers) IV V VI Interpurchase times* (across 5000 customers) VII VIII IX Purchase Amounts* (across 5000 customers) X XI XII Actual Predicted Average Average CLV ($) CLV ($) Extended Gamma / Gamma # * MAD statistic Actual Average Lifetime* (months) Predicted MAD Actual Predicted MAD Actual Predicted MAD Average statistic Average Average statistic Average Average statistic Lifetime IPT IPT Amount Amount (months) (months) (months) ($) ($) 24.18 13.3 and is understood in a similar fashion as explained in Section 4. Therefore.23$ for this extended model.06 3. Most of this improvement is accounted for by improvements in the purchase amount prediction [Table 8].5. The most challenging of these contexts with respect to CLV estimation is the 28 .40 Lifetime Value as on the slice date of January 01.06 0.50 1.

We then have a metric (the actual lifetime and actual CLV) to compare predictions across various CLV models estimated. We propose a flexible Generalized Simulation-based Framework (GSF) which can be used to propose and estimate a variety of CLV models (including the Pareto/NBD and BG/NBD models) in a noncontractual context. 2005). The challenge lies in forecasting drivers of CLV in a situation where customer defections are not observed. the flexibility of the framework in formulating and estimating models to measure CLV is limited only by the availability of statistical distributions. The framework uses the concept of data augmentation (Tanner and Wong.g. the interpurchase times and purchase amounts. forthcoming). We apply our framework on data from a direct marketing company that includes information about customer defections. The data set is unique in the sense that it allows us to act as if we do not know when the customer defected and then estimate models in a noncontractual setting. Further. These models make specific assumptions on the defection process and the interpurchase times which may not be suitable in many situations as shown in the extant literature (e.g. In a noncontractual context. van Dyk and Meng. We 19 Past research has pointed out the difficulty in estimation using the full model likelihood of the Pareto/NBD model (Fader et al. they are: (1) It generalizes the existing models to measure CLV in a noncontractual context. Therefore there is a need to develop methods that allow a firm to propose and estimate a variety of CLV models in such noncontractual contexts. 1987. Borle et al.noncontractual context where a firm does not observe customer defections. Any standard statistical distribution can be used for modeling the unobserved defection process. 2001) and offers significant advantages over existing alternatives. Thus. 29 . and (3) The estimation procedure being simulationbased circumvents the necessity of ‘computationally difficult’19 likelihood calculations as in the Pareto/NBD model. the Pareto/NBD and the BG/NBD models. two well regarded models to forecast drivers of CLV are the Pareto/NBD and the BG/NBD models. (2) It is flexible. it is easy to incorporate covariates and correlations across drivers of CLV in a model proposed and estimated using the GSF. e. This paper attempts to address this issue.

the framework allows estimation of CLV models with covariates and correlations across the drivers of lifetime value. we believe that the proposed framework is an attractive and flexible option for a firm wanting to estimate CLV in a noncontractual context. We then systematically change the distributional assumptions on the defection process. Further. 30 . the Gamma/NBD. and the development in computing facilities. and the Gamma/Gamma. it may require more time to estimate than other approaches as it is a simulation-based method. The framework allows any standard input distribution for customer lifetime. as we demonstrate.find that our proposed framework when used to estimate the Pareto/NBD and BG/NBD models replicates the results of their estimation using existing traditional approaches. the interpurchase times and purchase amounts to demonstrate the flexibility of the proposed GSF in formulating and estimating various CLV models. and customer spending. interpurchase time/purchases. In particular we estimate three additional models namely the CMP/NBD. However. given the significant advantages it offers. Although the proposed GSF has very appealing characteristics.

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