Detecting and Reducing Supply Chain Fraud

Norman A. Katz

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781409407324
• eBook ISBN: 9781317151982
• Topic: Law
• Subtopic: Business General
• Index: Law

Norman Katz has secured a top spot as one of the Top 50 Global Thought Leaders and Influencers on Supply Chain 2020.

For most large organizations, the supply chain is a commercial advantage, enabling innovation, cost management and resilience. But the supply chain is open to fraud: the length and complexity of it creates opportunities for fraudsters to exploit phantom inventory, invent non-existent customers or suppliers, substitute one product for another, cheat on the quality...this list goes on. These frauds present a significant source of additional cost to the organization and expose it to a host of secondary risks: contract, compliance and reputation.

Detecting and Reducing Supply Chain Fraud is a pragmatic guide to identifying and managing sources of risk. Norman A. Katz explains the main categories of fraud risk: what they are, what is their significance and how they are exploited by the fraudster. He also explores both the tactical and strategic approaches that you should adopt to help detect and reduce fraud, including detection techniques and the use of technology. He provides tactics for increasing your organization's resilience: increased transparency, appropriate governance, and engaging employees, customers and suppliers in more ethical work practices.

If you are responsible for your organization's supply chain, or perhaps involved in audit, compliance or risk management, start using Detecting and Reducing Supply Chain Fraud and look more closely at every aspect of your supply chain, both internal and external. The savings made in fraud reduction, the increased resilience you will give all of your operations and the improved reputation that your business will enjoy, as a contract partner or amongst stakeholders, will repay your investment a hundred-fold.

PART I Understanding Supply Chain Fraud

1 What is the Supply Chain?

DOI: 10.4324/9781315576787-1

Without purposefully adding yet another definition of the supply chain to the existing ones, it is important in the discussion of supply chain fraud to broaden the scope of what the supply chain represents. As the ideology and applicability of the supply chain concept continues to grow, the definition needs to encompass the overall spectrum of business activities without being tied to a particular industry type. My definition of the supply chain is as follows: The movement of something between a supplier and a customer from start to finish.

Now let us analyze the components of this definition. First, something moves. It does not really matter what it is: raw materials, components, finished goods, monies, services, data or information (the latter being the more intelligent version of the former), and documents. Conceptually, the supply chain is a line of interconnected links and it is along this path that something moves from one link to the next in sequential order.

Second, something moves between a supplier and a customer. Traditionally the concept of the supplier and the customer were of entities outside the walls – physically even more so than literally – of an organization. Suppliers provided something that an organization purchased and customers purchased something that the organization provided. But in a broader sense the supplier and customer could be internal or external and could be entities belonging to the organization, independent entities not belonging to the organization (whether located internally or externally), or a combination of these. The existence of the internal supplier and the internal customer relationship – both belonging to the organization – has been around for a long time. Imagine an organization’s Information Technology (IT) and Human Resources (HR) departments. These departments supply goods and services to the other departments in the same organization, which represent their customers. (The IT and HR departments are examples of entities who are both suppliers and customers as it is likely that each of these departments relies on suppliers for professional services and goods. Most suppliers are at some point customers themselves and most customers are suppliers of a product or service.) Similarly, there are other internal supplier–customer relationships, such as those identified in Table 1.1, that exist in a manufacturing organization.

Table 1.1 Internal Supplier–Customer Relationships

Internal Supplier	Internal Customer
Receiving	Quality Assurance
Quality Assurance	Inventory Control
Inventory Control	Manufacturing
Purchasing	Accounting (Payables))
Sales Order Processing	Accounting (Receivables)

In industries such as the automotive and electronics industries, some independent suppliers will set up shop within their customers’ manufacturing facilities, representing an example of an external supplier being located within the customer’s physical walls. This closer supply chain relationship can represent greater control over inventory levels and can reduce replenishment cycles, resulting in significant efficiencies for both trading partners.

Third, something is moved between a supplier and a customer from start to finish. How something is started and finished is rather subjective and is dependent upon which link we are located at in any given supply chain. During a manufacturing process we may look at a particular work-in-progress assembly or fabrication step, or we may consider the testing of samples by a quality assurance department prior to the acceptance of raw materials or finished goods. In a financial institution this could represent the movement of a loan contract from one department to the other to determine the requestor’s viability for the loan amount, or it could represent the transfer of money when the bank provides loan funds to a customer.

It is important to note that: It should be unacceptable to allow the move of something that was not of appropriate quality, especially if there is an expectation that the movement of something of less than appropriate quality could result in its return to the supplier or subsequent disruption of the supply chain. The determination of what constitutes something of appropriate quality depends on the particular industry supply chain and the requirements of the given customer, e.g. manufacturing versus financial. In manufacturing, raw materials must pass specific tests for purity and tolerance to engineering specifications in order to be deemed first-quality. In a financial institution, a document that is not first-quality may be missing necessary information or approval signatures that should exist at a particular supply chain link and are required to move the document on to the next step.

1. there is a handoff of something from the supplier to the customer;
2. there is a transfer of the responsibility for that something from the supplier to the customer; and
3. the move is complete or whole, in that there should be no expectation that the move is not permanent in nature for whatever reason.

The gaps in responsibility and completeness are root causes of finger-pointing when problems arise. Each party – the supplier and the customer – can look to blame the other for the condition of the something that was moved that resulted in a particular failure, or the need for redundant efforts, such as the customer’s return of something to the supplier. It is in this gap that organizations suffer excessive costs due to higher than necessary overheads from the results of failure and inefficiency, e.g. if the customer became burdened with the responsibility of fixing problems that the supplier should have caught and corrected before the move. It is also within this gap that fraud can occur, just as it can occur within a link itself. Reducing the amount of movement in a supply chain can equate to reducing the number of incidences of fraudulent activity.

Enterprise Resource Planning Systems

Originally, Materials Requirements Planning (MRP) software applications helped manufacturing companies determine how much of particular raw materials were needed, based on planned or projected inventory levels of finished goods against the organization’s overall capacity to make something. Bills of materials, operations, and labor represent the key aspects of manufacturing finished products: The bill of materials lists which ingredients are needed, the bill of operations describes the order of the manufacturing steps, and the bill of labor retains the amount of human effort needed per operation.

As businesses became savvy, the need to interface MRP systems with the software applications of the other areas of the business, such as the financial areas, became more necessary. Traditionally, companies would run “best-of-breed” software applications to support the distinct functional departments. (In my view, the “best” software or solution in general is often the most functionality that one can afford.) The “best” MRP software ran the manufacturing side of the business, the “best” accounting software handled all the financial needs, and the “best” order entry software ran the sales order processing department. These disparate systems would pass batches of data files between each other, typically at night, to provide the necessary updates. As the real-time needs of businesses grew, so did the realization that it was necessary for one comprehensive software application to handle all the operating, administration, and accounting requirements of the business, linking together all transactions and without the need for batch data processing and the necessity of running an organization based on reports from different software applications. Thus, MRP (and later MRP II) software applications morphed into the modern Enterprise Resource Planning (ERP) systems.

ERP systems may be on the edge of an evolution themselves: New buzz-phrases such as “Beyond ERP” and “Enterprise Architecture” are emerging as the next generation of enterprise applications. If what goes around comes around, there seems to be a movement toward establishing “best-of-breed”-type enterprise applications to replace single ERP systems that are too weak in some functional areas needed by clients or that are demanding too much financial investment in terms of maintenance and license fees. Regardless of what the future holds for the enterprise application, there will still be a need at the core – whether it is one application or several interconnected applications – to retain foundational business information and track financial transactions. Thus, in the discussion of the supply chain fraud referencing, an organization’s (traditional) ERP system changes nothing; business is still business and we still need specific software applications to hold our business information and capture our business transactions. Nor does it necessarily matter whether the core applications are run on mainframes, client-server architecture, or in a cloud.

These manufacturing concepts are applicable to other sectors such as the legal, finance/banking, education, and health care sectors. For example, the completion of a financial transaction requires materials (e.g. documentation), various operations, and labor at each operational step. Note that my definition of the supply chain is not targeted at any particular industry but is applicable generically. Supply chain fraud is not an industry-specific problem. Readers should be drawing parallels between traditional manufacturing concepts and their own industries because these parallels do exist. Examples in this book refer to manufacturing organizations because of the extra level of detail that can be showcased and the fact that manufacturing cuts across so many industry types, but there is equal applicability to distributors who purchase finished goods, banking and investment firms, law firms, hospitals and other medical practices, educational institutions, etc. What a manufacturer or distributor calls its “customer” (the outside entity it sells its finished goods to) a law firm calls its “client,” a hospital calls its “patient,” and a college or university calls its “student.” Fundamentally, each of these different industries runs its own form of an ERP system, and in fact some ERP software companies offer industry-specific solutions based on their core application product.

The supply chain operations of an organization are generally defined by the functions of its ERP system. Overall, ERP systems are the comprehensive software applications where organizations (a manufacturer is used in this example) store their business entities (see Table 1.2) and generate business transactions (see Table 1.3) that are recorded against their respective accounting ledgers.

An organization’s standard operating procedures manual on how to use its ERP application in support of its business processes should represent the flow of its supply chain operations. The ERP system is a critical supporting technology of an organization and its supply chain operations, and is also a central technology to the detection and reduction of supply chain fraud.

Table 1.2 ERP System Information

ERP Entities
Customers
Suppliers
Raw Materials ^*
Finished Goods ^*
Components ^*

* Including quantity on hand, quantity by location, and value.

Table 1.3 ERP System Transactions

ERP Transactions
Purchase Orders
Sales Orders
Work Orders
Invoices
Pick Tickets
Accounts Payable
Accounts Receivable
General Ledger

The Holistic Supply Chain

The traditional reach of the supply chain has to be redefined in the discussion of supply chain fraud. Suppliers are no longer local and thus are more difficult to connect with and exert control over. Outsourcing has become a commonplace strategy for the cost-effective acquisition of capabilities, especially those not within the core expertise of an organization. Even under the same organizational umbrella, it is no longer unusual to find divisions or departments housed in different facilities across a large geographic area. Employee telecommuting is g...

Table of contents

• Cover
• Halftitle Page
• Dedication Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• Preface
• Preface
• Introduction
• PART I UNDERSTANDING SUPPLY CHAIN FRAUD
• 1 What is the Supply Chain?
• 2 What is Fraud?
• PART II DETECTING SUPPLY CHAIN FRAUD
• 3 Catalyst Event Frauds
• 4 Purchase Order Frauds
• 5 Distribution, Shipping, and Receiving Frauds
• 6 Quality Assurance Frauds
• 7 Inventory Asset and Fixed Asset Frauds
• 8 Manufacturing Frauds
• 9 Invoice and Sales Commission Frauds
• 10 Return Frauds
• 11 Detection Do’s and Don’ts
• 12 Technology Methodology
• 13 Due Diligence in Detection
• 14 Fraud Ramifications
• 15 Reducing Fraud through Transparency
• PART III REDUCING SUPPLY CHAIN FRAUD
• 16 Beyond the Hack
• 17 Governance and Fraud
• 18 Trends in Ethics and Integrity
• 19 Supply Chain Information Integrity
• PART IV SUPPLY CHAIN VENDOR COMPLIANCE
• 20 Collaboration versus Conspiracy
• PART V FRAUD DETECTION: PAST, PRESENT, FUTURE
• 21 Predicting the Future of Supply Chain Fraud
• Online Resources
• Index