How can SpaceX be so cheap?

I had the opportunity to ask Gwynne Shotwell, the president of SpaceX, how they could be so much cheaper than their competition.  Her response was pretty simple: vertical integration.  

Vertical integration is a fancy way of saying SpaceX does everything in-house while other companies use contractors.  Since each contractor needs a profit on their part, the true cost of everything gets marked up.  Her rough math was if each contractor needs 30% profit on each project, and you do that 4-5 times, you end up with something that costs 3 times more.  Currently, SpaceX is roughly 3 times cheaper than other rocket companies.

The first question I asked myself is why no one has done this before.  It’s pretty clear why it’s difficult for someone to start a company to do the same thing.  Starting a space company is really capital intensive - Elon Musk put in $100 MM of his own money.  In addition, NASA was in a time where it had retired its shuttle program and wanted some way to continue missions to the international space station.  As a result, they came up with programs to award missions to commercial companies. 

But what about existing launch services providers (aka. rocket companies) like United Launch Alliance or Orbital Sciences?  These are the companies who currently launch most US government satellites (for example, for the US Air Force and National Reconnaissance Office). Couldn’t they vertically integrate everything and get huge cost savings? 

It seems there are several strong reasons why they would not have.  

First and perhaps more importantly, these providers are not incentivized to lower price.  Government purchases launches generally on a cost plus basis, that means they pay what it costs the provider to make the rocket plus a bit more (say 30%) to allow for profit margin.  The perverse thing here is the higher the cost, the higher the absolute profit (in dollars) for the provider.  At the very least, there isn't an incentive for lowering the cost.

Second, investing in building capabilities in house is hard and expensive.  It is hard to be an expert in everything.  For example, in the world of personal computers you have Intel building processors, Rambus making memory, and Dell marketing and selling the computer.  These companies have specialized at what they are good at.  Similarly, United Launch Alliance might not want to become an expert at building their own rocket engines - they can buy them from Rocketdyne or another such company.

Finally, no other launch provider has succeeded as a vertically integrated company in the past.  Thus, there is no evidence that what SpaceX did was actually going to work.  As companies with a stable business and a responsibility to their shareholders, it may have been seen as irresponsible to decide to vertically integrate everything.  

Put another way, imagine you are making a decision for United Launch Alliance on whether to outsource a part.  For the last few decades, engines have always been contracted out, you have done analysis which says building engines in-house will require a ton of investment and may take years to figure out, and, what's more, no one has ever succeeded in making money by building them in house.  Would you tell your boss that you think it's a good idea to build engines in house?  It would take someone rather insane to do so.