Below shows the difference between an image file (jpeg, bitmap, etc.) versus a vector file (.ai, .eps, etc.).

This is the original full size image.  The images below are zoomed in on the lower center part of the image.

This is a VECTOR file zoomed in close.  As you can see the edges are smooth.  The edge will stay smooth no matter how much you zoom in.  Therefor, if you take a vector file and make it really large, it will still look perfect up close.

The image above shows a jpeg of the same file.  You can see that the edges are not near as smooth when zoomed in as with the vector file.  Therefor when you take a jpeg (or any raster style image) and make it into a large decal, the edges won't be smooth when viewed up close.

So what type of file should be used to make a decal?

It should be obvious that if you have a vector file available that is what should be used.  Using a vector file also gives the software a "cut line" so the decal can be cut right up against that smooth line. 

But image files can still be used too.  There are going to be limitations to how large the image can be made and still look good.  Some images can be converted into vector art (required if the decal is to be die-cut).  There may be a set up charge involved depending on how complex the design is or how the quality is on the image.

Most decals on FastDecals.com are created from vector files but occasionally images are used when they are of good enough quality to be made into large decals.

Here is a good way to test how large you can go converting an image into a decal.

1. Put the image on your computer screen you want to use. 
   
2. Zoom in to what you feel is the size you want the decal to be.
3. Step back away from the monitor at the distance you will normally be viewing the decal.
4. If the image still looks good then it will look good as a decal.  Remember that the decal will only look as good as the image you provide.

Vectorization can be done in Adobe Illustrator and several other programs.  Most vector files will be saved as .ai, .eps, .svg or .pdf though they won't always be vector files if saved with those extensions.  Looking for a free vector program that you can edit vector files yourself?  Try InkScape.