The report adds to other signs that manufacturing is struggling around the globe.
The report followed other data showing manufacturing has slowed overseas. A measure of factory activity in China fell to its lowest level in more than three years last month. And manufacturing in Europe has also stagnated in the face of the region's financial crisis.
U.S. factories have been a key source of jobs and growth since the recession ended in June 2009. But the sector has shown signs of weakness in recent months.
The ISM survey showed factories kept hiring in July but at a slower pace. And production dropped sharply to 47.2.
Factories reported less demand in the spring after consumers cut back on spending and businesses invested less in machinery and equipment. Some worried that manufacturing could weaken further in coming months if Europe's financial crisis and slower global growth cut demand for U.S. exports.
Recent data suggest the economy picked up a little in July, which could boost factory production in the second half of the year. Employers added 163,000 jobs, the best hiring since February. And consumers stepped up spending last month after earning a little more.