Crafting in Divinity is based on merging two ingredients into one object. Some of these products can be further used as ingredients. Many types of items can be crafted: food, potions, magic scrolls, books, armors, weapons, etc. Some items can be created in any place, but some require an anvil/forge and tools. An anvil with a forge can be found in every city and the tools are frequently found during exploration of the world. They can also be bought from merchants and are rather cheap. Crafting can be done in the inventory tab, by dragging one item onto another - if they can be merged together, a window showing the result will appear, and if not - they will go back to their places in the inventory.
To create most of the items, especially those more complex, you will need a particular level in the Crafting ability. It is good to choose one team member and develop his Crafting ability to its maximum (5) or enhance it with the equipment. This will benefit not only in increasing the number of items that can be crafted, but also in better quality of the items from lower levels.
Blacksmithing consists of first creating metal ores and then items like swords or armors. It is a separate skill that should also be developed. You will find more information below, in a proper chapter.