How I did it and how it should be done are two different things.One I'm lazy. Two I'm cheap. Here is a link to actual instructions on eHow and even better, here's a link to a whole slew of design ideas and often step by step pictures for visual learners on one of my favorite blogs: Doggie Stylish.
Now back to me being cheap and lazy.
Fabric stores in the area are few and far between, so I made a quick stop at TJMaxx and checked the clearance section. I found a 4 pack of napkins for $5. What you're looking for is a stiff cotton that can hold it's shape, feel free to use what you have in the house.
You should take measurements of the dog's neck, length, and collar to come up with the size you need. I just winged a baseball home plate shape. The top part needs to be big enough to fold over and allow a collar to slip through. What should happen next is that all the seems should be folded over, ironed down, and sewn in place. Doing this will make your bandanna last longer. Yeah, I skipped that too. All I did was hand stitch the flap. You can then embroider or stencil your design. Me, sharpie. To do it right will take 15 minutes, do it fast in 5.
One tip though is have a spare collar for this; trying to keep the thing in line when your going to for a walk can be a nightmare if you don't. Otherwise you can get really crafty and make a hole where the ring sticks up to attach the collar. But if you're that good, you already know all this and probably laughed at my first project.