Sector spotlight: Fraud risks in manufacturing

Taking a step back: Understanding fraud in the sector

The manufacturing sector is integral to India’s growth story, with its sub-sectors such as automotive, engineering and pharmaceutical driving employment and contributing to GDP. Unfortunately, the sector faces its own set of challenges, impacting growth. Traditionally, one of the pain points for manufacturers is managing margins, a challenge especially dominant for certain sub-sectors. The problem gets aggravated with incidents of fraud, which further eat into bottom lines, affecting the profitability and long-term growth of companies in the sector.

Inevitably, fraud risks not only hurt bottom lines but bring with them other serious implications - reputational and regulatory. The outcome is a vicious circle, which drains resources and hurts employee morale, consumer confidence, and shareholder and investor trust. The case to mitigate and prevent fraud in the sector is therefore clear - to prevent potential losses, fortify business and gain a competitive advantage.

What makes the manufacturing sector vulnerable?

Manufacturing is particularly susceptible to fraud due to high stocks of inventory (raw material, finished and work-in-progress goods), making it a sweet spot for inventory fraud schemes and non-cash theft.

Bribery and corruption from third-parties and traditional fraud schemes like cooking books of accounts/financial statements continue to proliferate. In recent times, while the sector is gearing up to draw the benefits of technology and automation, fraud risks from this source are on the rise. Some of the peculiar characteristics of the sector which make it susceptible to fraud are as follows:

• Unmonitored supply chains, which are a potential loophole for fraud to occur. Lengthy and complex supply chains involve multiple physical facilities and several interrelated components, which breed potential risks at various stages - from sourcing of raw material until the final product reaches the consumer.
• Host of third-parties dominate most sub-sectors, including pharmaceutical, automotive, textiles and aerospace. Unethical actions of one third-party have a direct (and adverse) impact on the entire organisation.
• Underlying assets in the form of inventory, which carry a high risk of inventory fraud or theft.
• Government touchpoints for obtaining licences and permits and associated risk of bribery or speedy payment.
• Multiple and frequent transactions, often low in value, which are susceptible to specific fraud schemes.

As per the Association of Certified Fraud Examiners (ACFE) 2018 Report to the Nations Global Study on Occupational Fraud and Abuse, occupational fraud in manufacturing resulted in a median loss of USD 240,000 in the 212 cases reported for the sector in the study. Further, manufacturing is one of the sectors where schemes of corruption pose a significant threat.

Some of the key potential red flags of fraud in the sector include:

• Excessive shrinkage in inventory
• Apparent connections between vendors and staff responsible for procurement or purchasing
• Abnormal rise in invoice volumes, inflated invoices or multiple payments made to vendor/s without any corresponding services rendered
• Vendor/s consistently awarded contract despite poor performance or absence of any differential advantage as compared to the competition
• Sudden and unexplainable rise in customer complaints. This may be attributed to counterfeit products, a problem especially rampant in online marketplaces
• Payment of kickbacks to agent/distributors on account of diverting order to the company

Fighting fraud in the sector

• Make fraud risk management programme your starting point: For the manufacturing sector, address key vulnerabilities while drafting the fraud risk strategy is essential. Consider risks associated with third-parties and counterparties, non-cash fraud and conflict of interest. Another concern is fraudulent disbursements, which are fairly rampant and can be checked with appropriate segregation of duties.
• Internal controls are the key: Strong internal controls are crucial to deter fraud and timely detect its occurrence.
  • Appropriate documentation helps in maintaining a paper trail to monitor production process.
  • Keep controls in place to address issues arising from cash disbursements and encourage electronic modes of payment.
  • At a macro level, policies for reporting unethical behaviour, code of conduct, compliance with requisite regional and applicable global laws, etc., fall under the purview of robust internal controls and must be adequately provided for in the framework
    For any internal control to be effective, periodic reviews and monitoring are crucial.
• Leverage technology: Technology is now increasingly becoming the first line of defence for businesses to detect and prevent fraud in the sector. Use of sophisticated software and IT systems, analysis of voluminous data to detect potential anomalies and data monitoring can significantly reduce losses due to fraud.

Conclusion

The sector continues to be exposed to occupational fraud. This could significantly hinder growth and disrupt progress in the sector by discouraging potential new investment and hampering the opportunity for existing manufacturers and new entrants.

However, an ongoing fraud risk management effort, when established on a sound fraud risk assessment to identify existing and emerging risks, can mitigate the severity and frequency of fraud. It is important to diligently onboard and audit third-parties. While acts of fraud will continue, anti-fraud controls, when tailored to the sector and evolved over time, can significantly reduce or even eliminate threats of fraud.