Will the frog change into a prince? Predicting future customer profitability

More and more companies have customer databases that enable them to analyze customer profitability over time. These companies often seek to determine the most important customers as indicated by their current or historical profitability and focus attention on them. Focusing on profitable customers can result in more efficient use of marketing resources, but this approach neglects the fact that customers can evolve over time. Some customers begin as low-profit customers but eventually develop into high-profit customers. Others may start out as high-profit customers but become unprofitable over time. Previous efforts to predict future profitability have been relatively unsuccessful, with relatively simple, naïve models often performing just as well as or better than more sophisticated ones. Our paper presents a new approach to predicting customer profitability in future periods that performs significantly better than naïve models. We estimate the models on data from a high-tech company in a business-to-business context and validate the models' predictive ability on a holdout sample.We show that a model based on simulation of customer futures provides large improvements over naïve extrapolation of average profits. By using the simulation model to select customers, ROI from marketing efforts is projected to increase by 58%.