Assembly Lines of Defense: Internal Controls in Manufacturing

Of the nearly 2,000 cases studied in the Association of Certified Fraud Examiners’ (ACFE) “Occupational Fraud 2024: A Report to the Nations,” the manufacturing industry had the second most fraud cases reported at the time the survey was conducted. According to the report, organizations lose an estimated 5% of their annual revenue to fraud. The manufacturing sector, which fell behind banking and financial services, saw a median loss per incident of $200,000+. This industry is particularly susceptible to fraud because of challenges with complex supply chains, high volume of transactions, large quantities of inventory and weak segregation of duties, among other concerns.

Despite this data, many manufacturing companies don’t have the internal controls necessary to combat fraud effectively. Thirty-two percent of the fraud cases in the ACFE study occurred due to a lack of internal controls. Concerningly, our recent Manufacturing Pulse survey revealed a disconnect between confidence levels and actual preparedness among survey participants. While 86% of respondents expressed at least some confidence in their internal control environments, only 17% reported having an internal audit department. Sixteen percent of respondents indicated they rely solely on a code of conduct as their method of preventing fraud, which is even more concerning (full results from our survey here).

The Reality Behind Overconfidence

Confidence in fraud prevention measures is important, but misplaced confidence can be perilous. Our survey found that while 34% of executives are very confident in their internal controls’ ability to detect and prevent fraud, a deeper examination of their practices suggests this confidence may be tenuous.

For example, only 45% of Pulse respondents reported performing formal internal controls assessments. Companies that do not conduct structured evaluations of existing processes may fail to identify vulnerabilities that fraudsters can exploit. Even more surprising, only 12% of respondents reported having a whistleblower hotline—a proven tool for uncovering and reporting fraudulent activities. The ACFE report also showed that 43% of fraud cases evaluated for the study were detected by tips.

Overconfidence stemming from the assumption that an external auditor can protect a company against fraud is not advisable. Financial statement audits conducted by these professionals are designed primarily to provide reasonable assurance that a company’s financial statements are free from material misstatement—they are not intended to detect fraud comprehensively. External auditors have limited time and scope in their engagements and are not continuously monitoring a company’s operations. Because of these limitations, companies should not rely solely on external auditors to detect fraud but should instead implement strong internal controls, independent internal audit functions, and robust whistleblower mechanisms to mitigate fraud risk effectively.

The Case for Internal Controls

Manufacturing companies can use internal controls to prevent, detect, and deter fraud, minimizing or avoiding financial losses that can result from small issues escalating into major crises. Sound internal controls uncover inefficient processes and enhance financial reporting with reliable, accurate data. As a publicized fraud incident can damage relationships with customers, suppliers and stakeholders, internal controls also help protect a company’s reputation.

The ACFE report shows that preventing just one significant fraud incident can save a company hundreds of thousands of dollars, if not more.

Next Steps for Manufacturers

The manufacturing industry remains at high risk for fraud. It’s recommended that executives regularly evaluate their internal control environments. Here are three steps every manufacturing leader should consider:

1. Conduct a Comprehensive Risk Assessment: Identify areas most vulnerable to fraud, such as procurement, inventory management and payroll.
2. Build a Fraud Prevention Framework: This should include a formal code of conduct, fraud awareness training, regular internal controls assessments and mechanisms like whistleblower hotlines.
3. Invest in Internal Audit Capabilities: Whether through an in-house department or external consultants, internal audits provide an objective evaluation of controls and processes, ensuring continuous improvement.

Key Takeaways

While 86% of our Pulse survey respondents had some confidence in their internal control environments, not all of them reported having an internal audit department. Manufacturing executives cannot afford to go without internal controls. Learn more about implementing a fraud prevention framework or assessing your existing internal controls by talking to our team of leading professionals with expertise in the manufacturing industry.