Fraud Detection and Deterrence in the Manufacturing Sector

Every industry is subject to fraud risk, and the manufacturing sector is no exception. Compared to other industries, manufacturing organizations have some heightened risks that require particular attention. Areas of increased risk include corruption (especially in global supply chains), billing schemes, and misappropriation of raw materials and finished goods. Below, we examine fraud schemes that present a higher risk in manufacturing and provide some preventative and detective actions to help reduce that risk. 

According to the latest Occupational Fraud 2024: A Report to the Nations, published by the Association of Certified Fraud Examiners (“ACFE”), the median fraud loss in the manufacturing sector is $267,000, with an average loss of $1,816,000! This report also indicates that the top three schemes in the manufacturing industry are corruption (55%), misappropriation of noncash assets (29%), and billing schemes (27%). Additionally, the ACFE report indicates frauds involving both asset misappropriation and corruption occur concurrently in 35% of frauds. Therefore, it’s important for organizations to understand that the two largest schemes present in this industry may occur simultaneously. Across all the frauds covered within the ACFE’s report, more than half occurred due to lack of internal controls or an override of existing controls.  

Common Fraud Schemes 

Here are just a few schemes manufacturing entities must maneuver:  

Corruption and Bribery 

A manufacturer may source materials globally and/or have a global distribution network. When buying or selling throughout the world, an organization is subject to increased corruption risk. 

Misappropriation or Theft of Non-Cash Assets 

Manufacturing organizations can have large amounts of raw materials and inventory on hand. With some products, these raw materials can have considerable value. While these non-cash assets may be harder for the fraudster to convert compared to cash, they still have considerable value and are often not subject to as many controls as cash. 

Billing Schemes 

Because of the large number of vendors and payments for raw materials and other services related to manufacturing, there is an increased risk of billing fraud.  

Reducing Fraud Risk 

The best way to minimize your fraud loss is to prevent it in the first place; at a minimum, you need to detect it as soon as possible. According to ACFE, the most effective methods of detecting fraud in order of occurrence are: 

1. Tips
2. Internal audit procedures
3. Management review 

The following examples can help a manufacturing entity reduce fraud risk by maximizing the methods noted by the ACFE. 

Employee Education and Reporting 

Having frank discussions with employees about fraud does not increase the level of fraud but rather empowers employees to be on the lookout, which can alleviate some of the burden on management. Tips have been the most frequent method of identifying fraud across multiple editions of the ACFE’s report. Part of building a culture of fraud prevention is providing safe reporting mechanisms (e.g., a confidential hotline) for employees to raise their concerns.  

Surprise Inventory Audits 

Conducting unannounced physical inventory counts of noncash assets, raw materials and finished goods can ensure that your inventory records are accurate and send the message that management is watching.  

Management Review and Data Monitoring 

Management review and data monitoring reduce the length of frauds by approximately 50% versus those organizations that do not review/monitor, according to the ACFE. Management review and data monitoring also lower median loss when fraud does occur. In manufacturing, focusing on unexplained changes in inventory write offs, inventory turnover ratios, gross profit, and scrap loss may all be signs of fraud. While many sales functions have increased activity at the end of reporting periods, it is important that management conduct a review of those end-of-period sales to make sure they were not subsequently written off through receivable write offs or credit memos to revenue. 

Annual Fraud Risk Assessments 

Fraud prevention starts with knowing what your risks are. It is a best practice to include a fraud risk assessment during your annual risk assessments. If you are not conducting annual risk assessments, it’s well worth the effort to at least conduct some type of risk assessment on a periodic basis. During this process, you can identify the greatest risks facing your organization and then match your internal control processes to these risks. Any large risks without a matching control should be analyzed further. 

Periodic Vendor Master File Cleanup 

Periodic analysis of the vendor master file can help to identify or prevent a fraudulent disbursement from ever happening. Inactivating or deleting unused vendors as well as making sure the multiple entries for a legitimate vendor are combined eliminates these entries as a possible unauthorized payment destination. 

Vendor Disbursement and Credit Review 

Analyzing disbursements and credits can identify potential fraudulent disbursements. Typical procedures include looking for (1) groupings of payments just under an increased approval threshold; (2) even-dollar payments; (3) duplicate amounts; and (4) payments with purchase orders. 

Fraud Response 

While it’s preferable to prevent a fraud from ever happening in the first place, fraud does occur. In fact, your mindset should focus on when not if it will happen. 

The most critical period is when the organization receives a tip or uncovers warning signs upon management review or an internal audit procedure. The most common misstep is to dismiss an allegation or red flag. It is important that the initial evaluation of a potential fraud includes some personnel that are not connected at all to the area involved in the allegation.  

If, at this point, the organization determines that the matter should get further attention, having an independent party (internal or external) examine the matter further is critical to an objective and thorough evaluation. Lastly, consistent discipline is important to make sure that employees understand that the organization is serious about fraud. 

To reiterate, manufacturing organizations are not immune to fraud and have some specific vulnerabilities due to the nature of their industry. To reduce the impact of fraud, manufacturing companies need to be proactive. When faced directly with fraud, you must address the issue head on with independence and consistency. EisnerAmper has a depth of resources to help prevent, investigate, and analyze fraud perpetration in the manufacturing sector. Contact us below to discuss how we can assist.