The Australian Industry Group/PricewaterhouseCoopers performance of manufacturing index (PMI) fell 0.1 index points to 46.9 in July.
The reading was below the 50-point level, which separates an expansion from a contraction, for the second straight month.
It was also the weakest reading for the survey of about 200 companies since November 2005, when the PMI was 43.7.
Australian Industry Group chief executive Heather Ridout said the feebleness in manufacturing was not surprising considering the tighter financial conditions.
Data released this week from the Reserve Bank of Australia (RBA) confirmed tighter monetary times as demand for credit continued to soften with lending for housing, personal use and business grew at 11.5 per cent in the year to June.
This was the slowest annual pace of credit growth since November 2002.
The RBA lifted the official cash rate four times between August last year to March to a 12-year high 7.25 per cent, to curb inflationary pressures.
Commercial banks have lifted their lending rates independently of the central bank to cover their increased funding costs from the global credit crunch.
"The economy more generally, is feeling the ongoing impacts of the Reserve Bank's tightening of monetary policy as well as market-based rate rises," she said.
"Inventories were run down significantly, suggesting continuing weaker demand and the potential for further falls in production."
Manufacturing activity grew in five sectors during July, compared to two in June.
Machinery/equipment, chemicals/petroleum and coal products, and fabricated metal products all had moderate growth from mining and infrastructure-related demand.
"Manufacturers cited positive effects on activity from solid infrastructure and mining related demand," the report said.
The miscellaneous category, which includes jewellery, sporting and toy goods, had solid growth in July.
Activity grew slightly in paper/printing and publishing during July, its first rise in five months.
But a fall in housing construction, higher raw costs for steel, aluminium and fuel, keeping staff and the Western Australia gas disruption had negative impacts on activity.
Oil prices hit $US147.27 a barrel in mid-July, its record high.
Production and employment fell at a slower rate in July than the previous month.
However, stocks and new orders fell, placing pressure on production, the report said.
Manufacturing activity increased in South Australia and Western Australia but fell in the other states.
PricewaterhouseCoopers global leader of industrial manufacturing, Graeme Billings, said the fall in the Australian PMI for July showed continuing pressure on manufacturing profitability.
"The pressures flowing from slower market growth, rising input costs and the ongoing strength in the Australian dollar are a mix of both cyclical and long-term factors affecting profit margins," he said.
The Australian dollar reached a 25-year high of 98.50 US cents on July 16.
