Here is a description of the steps (and tools) that I use to cut and inlay pearl and abalone. As with everything described on this site, this is the way I have chosen to do it. This isn't THE WAY. This process has components of things I've read, conversations I've had with people who do this for a living, personal observation of my wife's stained glass design and cutting, and personal preference.
If you have never done inlay work before I highly recommend getting a copy of Pearl Inlay, by James E. Patterson (No ISBN) and reading it. It is a great reference. It is available from Stewart-MacDonald.
Prior to starting you need to have a design. I spent a considerable amount of time studying inlay work in various instruments and inlay pattern books to gain an understanding of how to best design inlays. If you wish to design your own inlays I would suggest that you invest some time studying how others have done it. This is more of a craftsmen's approach than an artists approach to inlay. I don't suggest studying others designs to copy them, rather to learn how others have done it so that you can arrive at a more visually appealing overall design of your own that flows from peghead thru fingerboard.
FQMS offers a number of pattern books that are very good references.
I use pearl cutting saw frames that I purchased from StewMac. I keep a medium blade in one and an extra fine blade in the other. I use a pearl cutting jig that I made myself. (The piece of wood in the picture below.)
For routing the inlay cavities I use a Dremel Digital Rotary tool and the StewMac Precision Router Base. The current version of this tool has a little fitting that you can connect to a small air pump to blow away the dust as you cut (that's the green hose in the picture.)
Another tool that I find useful is a very fine dental pick. It works great for holding the inlay as I trace it as well as picking an inlay out of a cavity when testing the fit. I also have made up some little blocks of wood with cork glued to them that I use under clamps (with waxed paper) when clamping the glued inlays.
Once I have a piece designed I trace it from the original drawing onto another piece of paper using a light table. Then I cut it out (Note: you only need to cut out a rough outline as you will cut the exact shape with the saw.) and glue it onto the pearl or abalone piece that I want to cut the design from. (A little tip I've learned from my wife and her stained glass work: Be sure to note the flow or pattern, including the irredescence, of the material, especially abalone, and try to use it in a way that will accent the piece that you are cutting.) I glue the design onto the pearl or abalone with regular old Elmer's glue. I use Elmer's because it is water soluble and allows the paper design to be easily be removed after cutting. If you need to have two or more identical pieces simply glue up multiple pieces, being sure to watch the pattern of the material as you glue them. I have glued up as many as eight pieces of pearl in order to get the eight identical pieces I needed to make the pearl circle for the compass rosette in the peghead. To cut these pieces I used my scroll saw with a medium pearl blade.
Once the paper design is dried on the material you can start the cut. Choose a medium, fine, or extra fine blade depending upon the intricacy of the design. Use the pearl cutting jig to hold the pearl or abalone on as you cut. I use a small air pump (the same one that's attached to the router tool above) to blow the dust out of the way as I cut. I don't have a fancy fixture to hold the air hose, I just lay it or hold it wear I need it.
Cut on the downstroke and take your time. Patience will result in a nice clean cut and an unbroken saw blade!
If you need to clean up the cut a bit you can use a set of needle files to do so.
Once the cut is complete simply soak the piece in water to remove the paper design. In the case of a lay-up of multiple pieces I find that putting the glued pieces in very hot water for awhile will release the glue and allow you to separate the pieces.
First you have to transfer the shape of the design to material in which you wish to place the inlay. To do this I simply hold the pearl or abalone piece in place with a dental pick while I carefully trace around it with a very fine pencil. I find this to be a satisfactory method of transfer. I have read that others lightly paint the area in which they are going to place the inlay with white or yellow Tempera paint in order to get a very high contrast to the wood (in my case ebony) in which you are placing the inlay. I find that I can see the pencil line on ebony just fine and don't take this step.
Once the outline is on the wood it's time to cut out the cavity. I always use a 1/32" end mill to complete the outline of the cavity first. You may find it useful to cut the outline in a counter-clockwise direction. This will help to prevent the end mill from grabbing and suddenly wandering off outside the intended area. In order to follow the outline closely I always use a magnifying headband (Opti-Visor from Stew-Mac) when I cut. Once the outline is complete, depending upon the size of the inlay, I may switch to a larger end mill to hog out the material enclosed by the outline. Once the cavity is complete I test the fit. Don't force the piece, it should drop in nice and cleanly. It may be necessary to clean up the outline until you get a perfect fit. (Note: save the ebony dust to put into the epoxy.)
Once the piece fits nicely it's time to glue it in. For this project I am using slow black epoxy from Stew-Mac. Before mixing the epoxy I prepare a clamp, clamping block, and a piece of waxed paper. When I mix the epoxy I add a pinch of ebony dust that was saved from the routing process. Fill the cavity with a toothpick. Be sure to work the epoxy into every part of the cavity. Once this is done, press the piece into the cavity. I typically squeegee the excess epoxy off and then cover the inlay with a piece of waxed paper, a clamping block, and then apply the clamp.
Once the epoxy has dried, to compete the inlay I use a scraper to remove the excess epoxy, clean up the space around the inlay, and bring it flush with the surrounding area of the fingerboard or peghead. If there are little pinholes in the dried epoxy I fill them with some fresh epoxy.
Here are some examples from a banjo peghead and fingerboard.