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When Apple’s next iPhone goes on sale in September, its upgraded core processor will be more powerful than that of any rival smartphone.

That’s possible because of Taiwan Semiconductor Manufacturing Co., which makes all of Apple’s custom chips. TSMC is using a new process to make smaller, faster and more power-efficient chips, which it refers to as 3 nanometer, for Apple roughly a year before it makes them for anyone else. But that’s not the only thing TSMC is doing for Apple: A sweetheart deal between the companies means TSMC effectively eats the cost of the defects that inevitably crop up in a new manufacturing process.

• Undisclosed deal explains why Apple is first in line for new chip tech

• Other TSMC customers do not get the same terms as Apple

• Apple is TSMC’s biggest customer by a wide margin

The arrangement will save Apple billions of dollars on iPhone, iPad and Mac chips, according to three people with direct knowledge of their deal.

The previously undisclosed commercial terms help explain how Apple can consistently be first in line to use TSMC’s advanced technology despite a high rate of defects. The savings are especially important for Apple, whose device sales have been sinking compared with where they were a year ago. And for TSMC, the orders from Apple are big enough to justify the added costs incurred from giving Apple a financial break.

“Apple and TSMC is the best strategic relationship in all of tech,” said Brett Simpson, a partner at technology research firm Arete Research. “Nothing comes close to their win-win strategy.”

The partnership is vulnerable to outside forces, namely China’s threat to invade Taiwan, where TSMC’s facilities are located. That prospect has drawn concern from other major customers, including Nvidia and AMD. Apple’s plan to be a customer of TSMC’s future fabrication plant in Arizona wouldn’t make up for losing access to Taiwan—and the Arizona plant has faced major delays.

The symbiotic relationship between Apple and TSMC, which The Information has chronicled in detail, began when Apple first used TSMC to produce chips for the iPhone 6 in 2014. TSMC’s special arrangement with Apple regarding defects began around that time, said one of the people with knowledge of the deal.

Sterling Reputation

TSMC charges customers such as Apple for making large batches of processor dies—the rectangular pattern that contains chip circuitry—on silicon wafers. Each wafer contains hundreds of dies, some of which are good and some of which are defective. The percentage of good to bad dies is known as the yield. Because TSMC has a reputation for manufacturing wafers with yields as high as 99%, it’s a preferred choice for customers including Apple, Nvidia, Intel and AMD.

But every time TSMC introduces a major upgrade, called an advanced process node, to its chipmaking, the defect rates of the dies stay relatively high until it can iron out the kinks. For 3 nm, the most cutting-edge node launching this year, the yield on wafers has recently been in the range of 70% to 80%, according to analysts, as well as one person with direct knowledge of the process.

That number would be a tough pill to swallow for TSMC’s customers, which typically pay for the wafer and all of the dies on it—including the bad ones. But in a break from standard practice, the Taiwanese manufacturer has only been charging Apple for dies that work—“known good dies,” in industry parlance—these people said.

However, Apple places such large orders from TSMC that the manufacturer can justify eating the cost of defects, said people familiar with the longtime arrangement. The iPhone maker’s willingness to be TSMC’s first customer for a new manufacturing process also helps the Taiwan company pay for research and development of advanced nodes and the construction of factories dedicated to them. Apple’s massive orders—it will reportedly ship 85 million iPhone 15 models this year—also means TSMC can more quickly learn how to scale up a new node for mass production.

And once TSMC fixes production issues and improves the yield on 3 nm nodes, other customers will be more willing to make their chips with the process. TSMC can charge those customers higher prices and earn higher margins, which includes asking them to pay for defective dies as well as good ones.

Spokespeople for Apple and TSMC declined to comment.

The arrangement has helped Apple maintain its lead in device computing power for years. It also protects the company’s product margins and may help explain why it hasn’t increased the iPhone’s retail price since 2017, despite the rising cost of chips and recent inflation. (Apple said last week its revenue in the quarter ending July 1 fell 1%, the third consecutive quarterly drop, as sales of iPhones, iPads and Mac shrank.)

Rising Costs

TSMC’s business boomed during the pandemic, when demand for consumer electronics skyrocketed as more people worked from home. Since then, a glut of chips and a slowdown in the global economy has weighed on TSMC’s earnings, and the company has said it expects a 10% drop in revenue this year.

Apple is by far TSMC’s largest customer, accounting for 23% of the Taiwanese chipmaker’s almost $72 billion in revenue in 2022. (In its regulatory filings, TSMC doesn’t identify its largest customer by name, but analysts and current and former TSMC employees confirmed it is Apple.) No other TSMC customer represents anything near that level of sales.

TSMC’s reliance on Apple hasn’t stopped it from raising prices. For example, Apple paid TSMC roughly $90 for the main chip in the iPhone 14 Pro, compared with $75 for the previous-generation chip in the iPhone 13, according to analysts at Counterpoint Research.

The cost increases might explain why Apple decided last year not to upgrade the core processor in the iPhone 14 and iPhone 14 Plus, reserving those upgrades for the higher-end Pro models. Analysts expect Apple to continue this trend as it looks to better differentiate its iPhones and push customers toward more expensive models. Some analysts have said they expect the price of this year’s iPhone 15 Pro models to rise $100 compared to earlier pro models, which would be the first price increase in six years.

Development Challenges

TSMC’s 3 nm node further shrinks the size of a chip’s transistors to pack more of them on a single chip without increasing its area. The 3 nm name, a marketing term, has no relation to the actual width of the transistors.

TSMC historically has introduced a new node every two years, allowing Apple to tout a major iPhone performance upgrade every other year. But the 3 nm node took an unusually long three years to develop as TSMC pushed up against the physical limits of how many transistors it could jam into a single chip. As a result, Apple released its flagship iPhone 14 Pro last year with only a minor upgrade to its chip, but it plans to use the 3 nm tech for the upcoming iPhone 15 Pro, according to people familiar with the device.

At the moment, Intel is the only other TSMC customer committed to using 3 nm in the near future, though TSMC won’t mass-produce those chips until 2024 at the earliest, according to analysts and a person with direct knowledge of the matter. Intel’s yields from some early production of TSMC’s 3 nm wafers have been around 70%, meaning roughly three out of every 10 dies don’t work. Unlike Apple, Intel has to pay for them anyway, according to the person.

A spokesperson for Intel declined to comment.