A craft idea utilizes salt dough to form the letters, after they have baked and cooled they can be decorated with pictures related to that letter utilizing paints or decoupage. To decoupage you can utilize stickers, wrapping paper or scrap booking materials. You will need to obtain some modge podge and some clear acrylic sealer. After you have placed the images on the letter coat well with the modge podge after this dries spray with the clear acrylic sealer. You might want to teach them to spell their name with this method and when it is done display it in their room. Instead of images geared towards the letter you might want to decorate the letters with items which represent the child and their interests, this would make for a great keep sake. This is just an option you could always just play with some dough to create the letters and be done with it.
How to Decoupage
While there are a variety of other sites on this topic I choose this one because the writer also discussed the use of modge podge.
Salt Dough Recipes
This site is nice it not only includes a couple different recipes for salt dough, but other home-made dough for children as well. The recipe I utilize when making salt dough does not include the oil, though we may try this next time.