As I was browsing a fancy shmancy paper store I was dismayed to find an expensive paper doll making kit. These ready-made "solutions" defeat the whole purpose and spoil all the fun of paper dolls. Some of my happiest childhood memories involved drawing little naked figures (with underwear -- I was a little unsure about anatomy) then designing, cutting, and assembling the most wild outfits I could imagine. You can make some pretty flashy outfits with wrapping paper, but my favorite in those days was cutting up the National Geographic to make illegal fur coats out of endangered species.
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Step 1: Draw the Dolls
Depending on your skill and confidence you can just sketch out a figure, copy a photograph (or live model) or trace an image. I prefer card stock, but construction paper or even plain old printing paper will work too. I find adult figures are best around 6", children around 4" (make them smaller and it will be hard to make clothes which stay on. Bigger and it will be harder to find pictures with good textures you can use for clothes).
Step 2: Cut and Color the Dolls
For drawing fine features and details colored pencils are usually better than felt pens, but really, anything goes when you're drawing guys and dolls. Use whatever you have and whatever you're most comfortable using.
Step 3: Belly Button Slots
This step is a good tip for making clothes stay on: give your dolls a belly button. Cut a slot right around the waist, and when you make the clothes you can incorporate a tab which fits right in and keeps everything in place. A scalpel knife is the best tool for this job, but a sharp pair of scissors can work too, if you're careful.
Step 4: Choose Your "fabric"
In these pictures I used holiday wrapping paper, but you can use anything you want: pictures of the sky from a magazine, a baby seal from a WWF flyer or even real fabric pasted to scrap paper.
Use your doll to trace the shape on your choice of paper for the clothes. Since not all clothes are skin tight, take the doll off once and a while as you're drawing the shape of the clothes to make sure you've got the design you want. remember you can also draw details onto your clothes: adding button and seams with a pen can give a good illusion of volume.
Step 5: Technical Details
You can't just design an outfit, you need to be able to wear it. When it comes to paper dolls the solution is fairly simple: tabs.
Before you cut out the clothes you've outlined in the last step, draw tabs which you will fold over the shoulders and sides to make the clothes stay on. Use pins to mark the spots for the belly button tab.
Step 6: Accessorize
I made a little dog coat to match the mom's dress, but you can make handbags, hats, shoes... This is by far the most fun part: designing clothes without sewing any seams or ironing!