Do Not Outsource! But If You Do, Remember These 3 Things

Ok, maybe the title is a bit provocative – this applies first and foremost to startup companies. This text is part two of Introduction to Lean Production Scale-Up Model. You can find the first part here.

What happens throughout the production scaling of a startup is a lot of learning in two equally essential sectors: From the market and customers’ needs (the market build-measure-learn loop), but also about the production process (the production build-measure-learn loop).

double loop

In the early stages of production scale-up, all work must focus on optimizing the learning process that can be best achieved when the production is done in-house. When using a subcontractor in the early stages of development, the company will also find it difficult to continue to the later stages of scale-up because the subcontracting partners hold the tacit knowledge and thus the negotiation power in the developing partnership.

It is tempting to outsource production or parts of it to speed up the development and reduce the need for capital investment. Subcontracting can indeed offer very tangible and attractive benefits: Facilities and supply chains are ready, and the need for upfront investments is limited to name a few, but these benefits are not related to the primary goal that is the efficient learning. If a subcontractor does the production at an early stage, the learning will happen at the subcontractor, not internally at the company.

Using a subcontractor also fights against some of the Lean principles. A subcontractor adds additional layers of management and material handling that do not add value to the customer. Additional material handling is especially the case if the subcontractor is used to do only some parts of the production. In such an arrangement, materials are loaded and unloaded between a different location that does not serve as a value-adding function.

An additional difficulty of using subcontractors in the early stage is the lack of incentives for the subcontractor to do continuous development of the production process and the suboptimal operational infrastructure of the subcontractor. Example of misaligned interests and operational infrastructure between the company and the subcontractor could be a situation where the company learns the clients want to pick up products evening time, but the subcontractor has nobody working after office hours. When you are the only client the subcontractor has requested this change in working hours you know completing this change will cost you a lot. In general, the subcontractor has minimal incentives to modify its operations to match the needs of one small client the best possible way.

One clear benefit a subcontractor can have is access to better prices and hard-to-acquire parts and machines. If this is the case, a subcontractor could be used to produce subassemblies involving these parts and machines. Yes, this would be a step for more complex and expensive, most likely also slower, production, but if this way is seen as the fastest way to learn, then it is the correct way.

If in-house production is not an option.

There are certain environments where in-house production is not a feasible option. Examples of these are regulated industries where you might have very long and expensive processes to get a certified production facility working from scratch.

Have your own people at the subcontractor.

If using a subcontractor is a must, the best possible option would be having the company’s own employees to run the production at the subcontractor’s facility. The need of hiring own employees can be restricted to the core functions of the production and to the parts that are related to the innovation, but the broader the scope of collected knowledge from the day-to-day work, the better. Warehouse management, packing, maintenance, and logistics are examples of the areas that could be left for the subcontractor to handle.

Use multiple subcontractors.

Hiring more than one subcontracting company is a method to position the hiring company better in long term negotiations. When the subcontractor is not the only one with the needed skills and machinery in place, the hiring company has a good position when difficulties eventually arise. In case of poor performance of subcontractor or if the subcontractor wants to charge you more of their work, having an alternative or two gives the hiring company good negotiation power. Having a second subcontractor means some increase in cost related to managing the co-operating, but the costs should not double.

Form a partnership with the subcontractor.

 

As explained earlier, one of the risks in working with subcontractors is the level of commitment for long-term co-operation. Financial investments for the joint project of production development by both parties can lower the risk. The subcontractor could invest in the hiring company and thus creating a clear incentive for developing the production together in the long-term. Other option could be establishing a common production company owned collectively by the innovation owner and the subcontractor. In the new company, the day-to-day management would be handled by the production professionals from the subcontractor, and the innovation owner would concentrate on research and development, marketing and other aspects of the business. The co-ownership would give both parties security as the success of the owners of the newly created company are intertwined.

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Introducing Lean Production Scale-Up

Lean Production Scale-Up is a four-step model designed for companies operating in untested markets with untested technology. The purpose of the model is the reduce the high capital risk that is associated especially with companies using new technology and innovations. The model enables the company to make its technology investments as soon as possible time-wise, but as late as possible in the learning curve.

I developed the model based on my experiences in production development in various startup companies both in the medical and food industries.

While the Lean Startup movement serves many types of startups, there is one aspect that has not been included in the broader public discussion. Lean Startup concentrates on finding the market fit for the product or service as efficiently as possible but assumes that the same level of uncertainty does not exist in the internal operations of the company. Companies like Spotify, Dropbox, and Facebook, had critical and untested assumptions regarding their business models when they started, but they did not need to doubt if the product was doable technically once market fit was confirmed.

The situation is critically different for companies that are involved in a business where the product or the production process is involving an innovation. Industries like 3D printing and food grown in bioreactors are operating in untested markets, but they are also working with unproven technology.

Build- Measure- Learn Double Loop.

Lean Startup focuses on optimizing learning by using the Build-Measure-Learn loop. For companies also having internal unknowns, a second loop is needed that is for the production process.

An Information Technology or service company must look into improving their working process for improvement as well, but in most cases, a software company is using existing coding languages, software, and hardware. When working with building new physical products with new machines and machine setups, new raw materials and so on the need for internal learning and improving the working process in the company is multiplied. Together, the two Build-Measure-Learn Loops form the Build-Measure-Learn Double Loop.

double loop

Figure 1: Build-Measure-Learn Double Loop

Lean Production Scale-Up Model

By using this model, a company with new innovation can navigate its way from an idea to full-scale production. Alternatively, in the case that innovation or the business model using it does not add value to customers or is not technically feasible, the company can identify this as soon as possible.

The Lean Production Scale-Up model consists of four steps. The model is divided into these exact four questions to maximize the efficiency of the scale-up process. Each step asks the question that the company must answer by using the Build-Measure-Learn Double Loop. The questions are answered one-by-one in the specific order.

The primary goal of the early production when working with innovation is not to generate profit for the company, and it is not to have a positive gross margin, but to reach the learning goals of each step and taking those steps as fast as possible. If you do something else than what is necessary at that step at hand, you increase your expenditure, risks, and what is worst you slow down learning and business assumption validation.

  • Step 1: Is there a demand? The question is quite similar to step 2, but asking first is there any demand at all, key assumptions can be invalidated without the need of financial commitments to production space and machinery that must be in place in step 2.
  • Step 2: Is the demand sustainable and scalable? After confirming that there is some interest comes the time to validate that the demand is not limited to too small customer segments and that the customers will turn into returning customers and advocates. Some investments are now needed, but only the ones that are necessary to collect the learnings are taken. All development ideas related to improving production efficiency are postponed.
  • Step 3: Is positive gross margin achievable? Once demand and market fit are clear, its time to confirm not only that the product can be produced on an industrial scale, but also that it can be done with a positive gross margin. At this stage when still operating with suboptimal machinery (the quick & dirty solution you have put in place so far) actually having positive gross margin is difficult, but you can collect evidence that positive gross margin can be reached. For example, changing too small warehouse to a larger one and investing in an automated packing line will improve your operational costs significantly.
  • Step 4: Continuous development. The company acquires the full-scale profit-generating production line. Learning is still essential for the young company, but the learning curve starts to slow down, and development starts to resemble established company: The development in the production process is now numerous small steps, while in the previous steps it was mostly fewer, but substantial steps. At this stage, the Lean Production Scale-Up has run its course and hands the control over to Lean Management that is specialized in continuous development.

By following the four-step model, a company with new physical innovation can navigate its way from an idea to full-scale production. Alternatively, in the case that innovation or the business model using it does not add value to customers or is not technically feasible, the company can identify this as soon as possible.

A major part of the financial risk involved in the production scale-up is associated with the relatively large upfront investments. Setting up a workshop, let alone a laboratory requires a set of tools and machines. Acquiring suitable working space and required tools is intensive investment wise. Making these investments as soon as possible time-wise, but as late as possible in the learning curve is the goal of Lean Production Scale-Up.

Avoid outsourcing

What happens throughout the Lean Production Scale-Up model is a lot of learning in two equally important sectors: From the market and customers’ needs (the market build-measure-learn loop), but also about the production process (the production build-measure-learn loop). It is tempting to outsource production or parts of it to speed up the development and reduce the need for capital investment. Subcontracting can indeed offer very tangible and tempting benefits: Facilities and supply chains are ready, no need for upfront investments or hiring production operators to name a few but looking for these benefits are not the purpose of the early stage production. If production is done by a subcontractor at an early stage, the learning will happen at the subcontractor, not internally at the company. All work must focus on optimizing the learning process that can be best achieved when the production is done in-house. When using a subcontractor in the early stages of development, the company will also find it difficult to continue to the later stages of scale-up because the subcontracting partners hold the tacit knowledge and thus the negotiation power in the developing partnership.

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Here you got a glance at what my Lean Production Scale-Up- book project is about! The idea is still fresh is only now starting to take shape. So far I have some 30 pages about the topic going more in detail how the four steps would look like in practice and what are the dos and don’ts for the starting company that is operating in the untested market with untested technology.

Would you like to read more on the topic? Any feedback on this blog post? Please get in touch by email or twitter!

Your friend, Ilkka Taponen