Vendor fraud can be a significant risk in the manufacturing sector, where companies rely on numerous third-party suppliers for raw materials, components and services. Deceptive practices can erode your manufacturing company's profitability, compromise product quality and damage relationships with legitimate suppliers. Such purchasing schemes usually are a form of occupational fraud, where an employee of the manufacturer carries out the violation. Here are some common vendor fraud scams and ways to lower your risks.

Phantom vendors

One type of purchasing scheme involves creating fictitious vendors. An employee in your purchasing department sets up a bogus supplier in the accounting system and then deposits payments to the supplier into his or her personal bank account.

Warning signs of fictitious vendors include invoices that are photocopied, sequentially numbered, and from companies that have post office box addresses or an address that matches an employee's home address. Also be wary of invoices with amounts that consistently fall just below sums that require approval for payment and, depending on your business, invoices for round dollar amounts.

Fake invoices with actual vendors

Some purchasing scams require collusion between an employee in the purchasing department and someone at the vendor's office. For example, a fraudster at the vendor submits falsified invoices. Then, the colluding employee in the manufacturer's purchasing department deposits payments into his or her personal account or splits payments with the accomplice at the vendor.

Connections between procurement staff and suppliers may provide clues to these schemes. Is an employee related to, or otherwise linked with, the owner or management of a supplier? If so, that employee shouldn't make purchasing decisions that involve the vendor.

Kickback schemes

In a kickback scheme, the person who approves a vendor contract receives payment or other personal benefits from the vendor. Unfortunately, cash payments to employees can be difficult to detect because those payments aren't reflected in the company's books.

Red flags of kickbacks include fewer bids than expected or required, widely divergent bids on the same projects, or unexplained deadline changes. Paying higher prices for lower-quality products could also indicate a possible kickback. So could consistent shortages, informal communication (such as phone calls, personal emails or texts) between purchasing staff and suppliers, and poor record-keeping.

Institute preventive measures

Reduce the opportunity to commit vendor fraud by strengthening internal controls and developing policies and procedures to prevent it. No employee should be authorized to handle all or most of your purchasing procedures. For example, someone who orders supplies and materials shouldn't also be the employee who checks shipments and approves invoices. Separate these functions or rotate who's responsible for them quarterly.

Also consider performing background checks on new vendors. Such checks can provide information on vendors' affiliations, ownership, litigation, regulatory or legal violations, and financial standing. This can help weed out vendors with dubious histories.

Manufacturers should also state in writing how they expect employees and vendors to conduct business. Review and update your code of ethics yearly and require employees and vendors to sign it. Annual reminders reinforce the idea that the company prioritizes ethical, professional business practices.

Anonymous hotlines — one for employees and a separate one for vendors — can help to detect purchasing fraud. Giving vendors a separate hotline makes them more comfortable sharing concerns and allows them to ask questions about your company's ethical practices.

Root out vendor fraud before it occurs

By proactively addressing vendor fraud risks, your manufacturing company can protect its financial health, maintain the integrity of its supply chain and ensure compliance with industry regulations. Conducting fraud risk assessments and implementing financial controls can further safeguard your business against costly fraud schemes.