What is E(P=R-C)M? Understanding the core of the P&L equation
August 5, 2022
The following is based on our lesson on P&L cases in our audio course on Case in Point
The E(P=R-C)M is a core part of profit and loss questions. If you want to ace your case question interview you need to understand it well. Let’s breakdown what it’s made of and how to use it to solve questions.
P =R — C: Profit = Revenue — cost
If you’ve taken any finance courses or run a business you’ll know the two core tenants of a P&L.
The first is that profits equal revenues minus costs. If you’re an acronyms person, you can simply remember that P (profit) = R — C. P =R — C.
The second is that revenue equals the price per unit multiplied by how many units are sold. Number of shoes times the price each shoe costs. All business common sense.
Don’t go micro, focus on the macro
Often, your instinct will be to dive right into those factors that involve the company itself and start analyzing the fixed costs and variable costs. How much is it costing the company to create and sell a shoe? Perhaps costs have gone up and that’s what is causing profits to drop.
Although this feels like a natural place to start, analyzing a company without the context of the industry is just wasting your time. You’ll get a much better picture of things if you start with the whole picture and then zoom into what’s going on in your specific company. In investing we call this the “top down approach.”
We’ll start with a clarifying question: “Are our competitor’s profits down as well?”
We ask this because we want to know if this is our problem or an industry-wide problem.
So before starting to explore the P = R — C, as in the profits vs revenue and cost, and what’s happening there, start with three external factors:
The specific market or industry the company is in.
For example how is the European market doing? Is the shoe industry growing or shrinking?
Why start with the macro before the micro? Because external factors give you an idea whether this is a company specific problem or an industry wide problem. You don’t live in a vacuum so you shouldn’t do your cases in a vacuum. Ask about the competitors in the marketplace. If their profits have also fallen, that could point to some external factor that our client needs to deal with. Perhaps a rise in tariffs, interest rates or the cost of raw goods.
By starting with the macro, as in the economic and market dynamics, you’re making sure you’re checking all relevant factors before you start micro analyzing the company itself.
When looking at the economy you should focus on two or three factors in the economy that are important to the client, not just economic trends.
When looking at the environment, whether it is COVID, a hurricane, or a particularly snowy winter you need to indicate how this as affected the company.
Using the E(P=R-C)M equation
This is how you use the equation. At the micro level of a company you have the profits of a company that are its revenues minus costs. That microcosm of the company is affected by the economy and business environment on the one side and the market conditions from the other side.
And that’s how you should analyze a profit and loss case question and use the E(P=R-C) equation. P=R-C inside parentheses and on the outside of the parentheses on either side you have the external factors: E on one side for the economy and environment and M on the other side for the market condition.