In their new book, Fundamentals of Supply Chain Management: An Essential Guide for 21st Century Managers, authors Kenneth B. Ackerman and Art Van Bodegraven offer a tour of the supply chain universe in the best "Star Trek" tradition. After they cover the basics (warehousing, transportation, material handling, and so on), the authors boldly go where few have gone before, exploring the strange new worlds of "lean" supply chains, supply chain migration, and the "green" movement. In other chapters, they return to the more familiar worlds of finance and accounting, human resources, and litigation, though always approaching the subject from a unique supply chain perspective.

This excerpt chronicles the history of supply chain fraud from the Trojan Horse (which the authors cite as an object lesson in the need for inbound inspection) to the shenanigans of two middle managers who circumvent a security program that the TSA would envy to divert truckloads of high-tech equipment into so-called "alternative channels." ("Think Tony Soprano. With better paperwork.") After tracing supply chain fraud through the ages, the discussion takes a more serious turn, concluding with an outline of a five-step anti-fraud program.

Our friend Whitney Massengill has observed, "A gang armed with guns can easily steal thousands. A gang armed with pens can just as easily steal millions—and the prison terms are shorter." Enron may have provided the ultimate proof of concept, but the supply chain world has been plagued by fraud and deceit since long before supply chains were known as supply chains. The manifestations, while often physical, are also found in the cooked books.

Not so long ago, it was stunningly easy to put an extra case or pallet on a truck for the driver to sell, splitting the take with the inside man. Today's information systems may make detection quicker, but collusion theft has hardly gone away. And in the meantime, modern forms of fraud have emerged, many of them complex—even elegant—in their design and execution.

The Classics of a Golden Age
It seems that fraud, in its infinite variety, has been around about as long as the human race. Some would cite Homer's Trojan Horse as an early example of logistics fraud, illustrating the need for inbound inspection. Maybe the good ol' days weren't so good after all.

The Teapot Dome scandal that engulfed the Harding administration involved shady doings around oil reserves.

Product adulteration or dilution has been practiced since the earliest times; it is not a modern phenomenon limited to the narcotics trade. Back in the day, it might involve such commodities as sugar, coffee, flour, and liquor.

Outright theft, of course, remains a staple occupation in some locales within our globalized supply chains. Some shippers deliberately send extra truckloads of product into known high-theft areas, knowing that they can expect to lose a predictable percentage of the cargo to hijackers.

An interesting variant of the extra-case scam involves unscrupulous suppliers who would ingeniously stack pallets with a case or a bag missing from the inside of the stack. The omission is not visible until or unless the pallet is broken down. But by then the goods have typically been paid for, and the missing case has disappeared into someone's personal supply chain.

Truth is, some of the more spectacular frauds in business history have had a supply chain management flavor.

In More Recent Times
In the annals of corporate misdeeds, the recent Enron scandal has overshadowed all others, and, of course, it had nothing to do with the supply chain. But what about McKesson & Robbins? In 1938, the giant wholesale distributor got caught up in a case of accounting fraud that involved a non-existent $10 million worth of inventory in Canadian warehouses that also didn't exist. The sum of $10 million was more than pocket change during the Great Depression. While considered at the time to be accounting fraud, the case might be more accurately described as a conspiracy between physical supply chain operations and accounting to perpetuate fraud. In the '80s, a large public accounting firm was brought down foreshadowing Arthur Andersen's collapse when entire manufacturing and storage facilities were belatedly discovered not to exist.

The '60s saw plenty of scandals as well. Billy Sol Estes, politically connected with Lyndon Johnson, managed a double whammy in the first half of the decade. First came the improper purchase of cotton allotments, aided by payoffs to Agricultural Adjustment Administration minions and complicated by the suicide of a principal antagonist. Then in a notorious exit from the public arena, Billy Sol was found to have extracted enough money to fund the illegal allotment transfers by using phantom fertilizer tanks as collateral. He was released from prison in 1983.

In 1963, in news largely overshadowed by the Kennedy assassination, Tino De Angelis, principally financed through loans guaranteed by American Express, was found to have storage tanks full of water. That wouldn't have been a crime, except that the tanks were supposed to be full of salad oil. AmEx was not pleased. Nor were Manufacturers Hanover Bank (among about four dozen banks), Bunge Corporation, Williston and Beane, and Ira Haupt Brokerage Company, all of whom got taken. Foreshadowing events that would unfold nearly four decades later, a major public accounting firm was ultimately accused of negligence.

It seems that De Angelis couldn't help himself. Earlier in his career, he had gotten away with selling bad shortening to post-war Europe and spoiled meat to U.S. school lunch programs. Encouraged by his apparent success, he then put together an ultimately failed plan to corner the world market in soybean oil.

Tino, only momentarily the pride of the Bronx, himself got taken, but to the pokey, for several years. Upon release, he attempted to recover his lost fortune with a Ponzi scheme,* which required more credibility to pull off than Tino possessed. The price tag of this oil escapade was a trifling $175 million, which would approach $2 billion in today's money.

Where Were the Auditors?
Uncovering fraud is not an arena in which the mild-mannered certified public accountant (CPA) has typically excelled. It's not that CPAs are naïve or feeble-minded, but that these aren't really the things they've been trained to run to ground. The auditing firms have been generally more concerned with matters that have material impact on the balance sheet or income statement—known material impact, that is.

Furthermore, because CPAs most often were not operations people, they didn't always know what to look for when physical inventories were involved. In one celebrated case, the fraud was so extensive that the company in question loaded bricks of approximately the right weight into sealed cartons ostensibly containing technological equipment. The physical inventory disclosed the right number of cases, and it never occurred to anyone that something else might be inside.

In another major event, the headquarters inventory was fine. But no one deemed the relatively tiny store inventories worth examining. Regrettably, fictitious transactions had moved mountains of non-existent product into phantom local stocks, creating enormous but false sales volumes.

Prevention
Over the years, companies seeking to prevent fraud have tried solutions as high tech as biometric screening and as low tech as intuition with approximately equal results. We vividly remember the very large international technology distributor that invested a lot of money in screening devices through which each and every employee, visitor, vendor, contractor, and consultant was required to pass. No one could enter or leave the DC at any time or for any purpose the start or end of a shift, in and out for lunch, or in and out for breaks without undergoing screening. The distributor's concerns were well-grounded because its products were both valuable and highly desirable in the consumer market.

While the working associates were queuing up to pass through a "security" process that would have made a TSA screener proud, however, two mid-managers were successfully conspiring until they were caught to move and sell truckloads of high-value product out of the distribution center and into what might be called alternative channels. Think Tony Soprano.With better paperwork.

So many times, it seems that thievery is discovered only after huge losses have been incurred over a long period of time. In another case we encountered, a chemical manufacturer for the automotive aftermarket became suspicious that product might be "leaking" out of its factory DC. In the end, its suspicions proved to be well founded. It turned out that thieves were taking a truckload of merchandise a day out of the DC and off the books through a scheme involving phony paperwork for phantom customers. But it took months of surreptitious observation and digging through paper and electronic files to come up with conclusive evidence and nail the individuals involved.

In another situation, no one in a catalog retailer's senior management ranks had even the remotest suspicion that a traffic manager of some 20 years' standing might be on the take. But a routine fact-finding analysis, with no agenda other than assessing potential improvements, found carrier selections that made no sense. The manager was allowed to quietly resign and keep the money, though it seemed that the offense called for a pistol-whipping at the very least.

An Organized Approach
In recent years, the impact of the Sarbanes-Oxley Act has been felt in the supply chain management arena, quietly requiring companies to put controls in place to prevent, identify, and detect fraud. PricewaterhouseCoopers (PwC), the public accounting and services giant, has published a white paper devoted to fraud schemes in the transportation and logistics sector. That white paper addresses not only the risks associated with financial reporting, but also the risks to a company's reputation and the legal and strategic implications of fraud. Ken Evans, the firm's U.S. transportation and logistics leader, has asserted that 45 percent of all companies have been victims of economic crime. (In the interest of full disclosure and in the spirit of Sarbanes-Oxley, we confess to being PwC alumni, having a predecessor firm as our consulting alma mater.)

PwC's five-step anti-fraud program is the usual straightforward, even dull, recitation, with the devil as well as the excitement and the effectiveness in the details. Its recommendations are as follows:

1. Establish a baseline, preferably with a multi-disciplinary team, that includes the development of remediation plans;
2. Conduct a risk assessment that is not only an inventory but also a weighting of likelihood and seriousness;
3. Evaluate controls design and effectiveness, with major roles and responsibilities for operating management;
4. Assess residual financial reporting risks, which link fraud risks to internal audit weakness and ineffectiveness;
5. Standardize incident investigation and remediation processes that recognize that fraud will occur in the real world, and demand that the gaps be filled on a continuous basis.

In PwC's assessment, fraud and misconduct schemes can be classified into the following six categories:

• Financial statement manipulation, which can be sub-divided into improper revenue recognition and the over- or understatement of assets and liabilities. This is really the mother lode, encompassing such things as manipulation of estimates, over-accrual of rebates and receivables, understatement of liabilities, overstatement of receivables, sham transactions with related parties, overstating revenue, fictitious transactions, premature revenue recognition, revenue leakage, backdated and side agreements, and "round-tripping," transactions with no net economic benefit that can inflate earnings.
• Asset misappropriation, including cargo theft, fraudulent disbursements, cash skimming, industrial espionage, and "lapping" or theft of customer payments.
• Unauthorized receipts and expenditures, including bribery, tax evasion, improper labor practices, and fraud against employees (e.g., failure to fund pensions or pay insurance premiums).
• Aiding, abetting, or helping a third party commit fraudulent acts.
• Senior management fraud, including, in addition to involvement in all of the above, conflicts of interest and insider trading.
• Disclosure fraud, including the intentional omission or misstatement of such items as channel stuffing, even if they conform to Generally Accepted Accounting Principles (GAAP), the usual gold standard for what practices are allowable.

We salute PwC for its work in this area. Its efforts could go a long way toward restoring accountants' reputation and credibility.

New Disciplines
We have reached a point of understanding the nature, variety, and scope of supply chain fraud, and the linkages between its physical and financial components. It's time for a couple of forces to join together in fighting these crimes.

Forensic Accounting has been around for a long time, certainly since the days when Al Capone was jailed for tax evasion instead of murder. We see a need for a newer specialty that could be called Forensic Logistics and would entail the analysis of operations for evidence of and potential for bad behavior.

Putting these two together might put real teeth in efforts to thwart supply chain fraud.

Excerpted from Fundamentals of Supply Chain Management: An Essential Guide for 21st Century Managers, by Kenneth B. Ackerman and Art Van Bodegraven, published by DC Velocity Books (www.dcvelocity.com/books). © 2007 by DC Velocity Books.