The Australian Industry Group-PricewaterhouseCoopers Australian Performance of Manufacturing Index (PMI) fell 1.5 index points in May to 51.2 points.
Last month's fall more than erased April's slender 0.4 point increase.
The index is now only barely above the key 50 point level, which separates expansion from contraction.
Australian Industry Group chief executive Heather Ridout blamed increasing energy prices and a stronger Australian dollar for the slowing in manufacturing activity.
"The fact that these pressures have been sustained for a long period of time have compounded the impact on the industry," Mrs Ridout said in a statement.
"Industry is going to have to work even harder on lifting competitiveness in order to maintain profitability and market share."
Manufacturers said demand for infrastructure, particularly from the mining industry, was having a positive effect.
But the lack of skilled labour, increased cost of raw materials, slower housing demand and weaker US growth was hurting.
Employment in the manufacturing industry fell for the third straight month in May.
Ridout said the Reserve Bank of Australia (RBA) needed to consider the plight of the manufacturing sector when it came to setting interest rates.
"Monetary policy needs to have an eye on the extraordinary pressures, which this large and very important sector of the economy continues to experience," Mrs Ridout said.
The RBA board meets on Tuesday to discuss interest rates and its decision will be announced at 1430 AEST.
Economists unanimously expect the central bank to leave the official cash rate unchanged at 7.25 per cent.
A softening in domestic demand was reflected in a significant fall in new orders in the month.
There was also a fall in capacity utilisation.
There was higher activity in Western Australia, but it eased in Queensland, NSW, South Australia and Tasmania.
Victorian manufacturers recorded "stable modest growth", the report said.
