Australia's manufacturing activity dropped sharply in July as businesses remained cautious about the economic outlook, according to a survey released on Wednesday by the Australian Industry Group (Ai Group).

The Australian Industry Group/PriceWaterhouseCoopers Australian Performance of Manufacturing Index (PMI) fell 6.9 index points to 40.3 in July.

Reading below 50 indicates a contraction in activity with the distance from 50 indicative of the strength of the decrease.

The index showed almost all sub-sectors experienced declines in activity in July except the food and beverages sub-sector which recorded a mild expansion.

The Paper, printing and publishing sub-sector recorded the largest fall in the month.

Ai Group said the manufacturing companies surveyed were still cautious about the economic outlook, citing soft demand, the carbon tax and the strong Australian dollar as inhibitors of activity in the month.

Ai Group Chief Executive Innes Willox said a variety of factors were behind the sharp drop in the local manufacturing industry in July.

"The industry is experiencing substantial pressures driven by the strong (Australian) dollar, cost increases, slow growth in domestic demand and competition from lower cost sources of production," he said.

"Manufacturers are responding by re-assessing and re-modeling their businesses but, as suggested by another drop in new orders and with the full impact of the carbon tax still to be felt, further falls in overall activity are likely in the months ahead."