If you're looking for quick and dirty methods for calculating the lifetime value of your customer base, the first and second post in my series are just what you're looking for. In this post we will dive into probability models and how they can provide a more sophisticated method for estimating LTV than the simple averaging methods discussed thus far.

Enter Probability Models

If we examine the purchasing activity of any group of consumers, we'll see that there's a natural variation in behavior between individuals. We can use probability models to take this variation into account when calculating lifetime value for any customer.

The probability model you'd want to use will depend on the business context it will be applied in. Ask yourself two questions:

1. Do my customers have a contractual relationship with my business?
2. Do customer transactions happen at specific times  or can they happen at any time?

Let's go over these two questions real quick and explain what they mean.

Contractual vs. Non Contractual

The first question you want to ask yourself when determining the optimal model to use for your problem if customers interact with your business on a contractual basis. Companies that operate on a subscription business model fall into this category. In contractual settings, the moment in which a customer ends their patronage can be observed. This is typically indicated by a customer deciding to cancel their subscription.

Customer lifetime value for contractual engagements can be estimated using survivor based models.

As for non contractual businesses, where the end of a customer's patronage is not known, the customer lifetime value is often modeled using exponential models.

Discrete vs. Continuous

After determining if you're dealing with a contractual or non-contractual problem, you next want to think about how customers will be making transactions with your business.

If your customers make transactions at fixed periods of time (i.e. weekly or monthly) than we call these transactions discrete. SaaS companies that bill their customers for services every month would fall under this category.

If on the other hand a customer can make a transaction at your business at any time the transactions are considered to be continuous. Purchases made at an electronic store would fall under this category.

The Business Contexts At a Glance

Combining the answers to the two questions previously covered you'll notice that there's four types of business contexts that can come up. Below are the four contexts and examples of businesses that fall under each.

Non-contractual settings with continuous purchases

• Movie rentals
• Medical appointments
• Hotel stays
• Grocery purchases

Contractual settings with continuous purchases

• Costco membership
• Credit cards

Non-contractual settings with discrete purchases

• Prescription refills
• Event attendance

Contractual settings with discrete purchases

• Magazine subscriptions
• Gym membership
• Netflix, Hulu, and other streaming websites

That's all folks!

In my next post I will discuss the Pareto/NBD model, a model that can be used to describe continuous transactions in non contractual business settings. Until next time.