By Paul Lukas Reporting by Maggie Overfelt

(FORTUNE Small Business) – A new Barbie doll is sold approximately every three seconds. The average American girl has ten Barbies. And 100% of mothers with daughters ages 3 to 10 can identify the doll by name (and, let's face it, probably everyone else can too). All of which helps explain why Barbie dolls alone sell more than $1 billion annually and it's become a cultural icon.

But Barbie's success, like her outsized figure, can divert attention from the bigger picture of what Mattel, the company that makes her--and Mattel's founders, Elliot and Ruth Handler--accomplished in addition to the fashion doll. More than just toymakers, the Handlers are the "founding mother and father of the promotional toy business as it exists today," write Sydney Stern and Ted Schoenhaus in their book Toyland (1990). "They're the first toy industry entrepreneurs to transform their company, consciously and systematically, into a professional operation." They did so in their early embrace of television, their marketing practices, and their innovative product designs that focused on children being able to interact with a toy. Not bad for two youngsters from Denver who stumbled on the toy business in a pile of wood scraps.

The story begins in 1937, when the love-struck 21-year-olds Ruth Mosko and Elliot Handler decided to move to Los Angeles. Ruth got a typing job at Paramount Studios for $25 a week, while Elliot designed light fixtures and studied industrial design. They were both bright and ambitious, but as the New York Times Magazine described them 30 years later, Elliot was the "creative one" while Ruth was a "one-woman sales-merchandising-promotion- administrative force, a sort of industrial Orson Welles." For a school assignment, Elliot sketched designs of the home accessories they needed, and Ruth was so taken with the drawings that she insisted they buy the necessary tools and equipment to produce samples, even though it was beyond their budget. She then took a day off from Paramount to peddle the samples on Wilshire Boulevard, landing a $500 order on her first try. The resulting company--Elzac, a merger of Elliot's name with that of a financial partner named Zachary--moved into giftware and costume jewelry and grew to be a $2 million business.

But Ruth had been sidetracked by motherhood, and Elliot felt stifled creatively by his partners. So in 1944, when a former Elzac foreman, Harold "Matt" Matson, proposed a new business building some of Elliot's designs, Ruth jumped at the chance. They called the fledgling company Mattel (again merging the men's names), and the firm's first products were picture frames made of low-grade lumber. Elliot used the leftover wood and some plastic scraps to make dollhouse furniture--his first foray into toy design. It was a modest success, helping Mattel turn a $30,000 profit in 1945 on sales of $100,000.

The Handlers were now in the toy business. "We didn't know how to run a business, but we had dreams and talent," Ruth told FSB in 1998. They also knew how to bounce back quickly from early stumbles. Mattel put out its first big toy in January 1947, a toy ukulele Elliot designed called the Uke-A-Doodle. But by releasing the uke two months before the industry's annual trade show event, the Toy Fair in New York City, the Handlers could only blame themselves when a number of companies were preselling a toy ukulele using Mattel's own product as the sample. The next year Mattel not only had learned to wait for the Toy Fair to debut its new products but also had begun producing ones complex enough, starting with a baby grand piano with raised black keys, to win patent protection, thus warding off copycats.

The stress of the toy business drove Matson out very early, but the Handlers continued, and their ingenuity soon outpaced their business naivete. Because they focused on design, sales, and marketing and subcontracted most of the manufacturing, they were the first company to make toys out of a variety of materials. They also presciently embraced the idea of reusing an element in a variety of toys, starting with a music box, which appeared most memorably in a jack-in-the-box that jumped out on cue to "pop" when a child cranked out "Pop Goes the Weasel." Said Ruth in her autobiography, Dream Doll (1994): "We'd developed a basic mechanism around which new products could be designed year after year." Mattel sold 20 million music-making toys in their first two years on the market and had to move to larger quarters five times.

The couple also used television effectively, first as a source of inspiration (Arthur Godfrey's affinity for the ukulele had inspired Elliot to make the Uke-A-Doodle), then as a tool for selling. The big breakthrough came in 1955, as Mattel, by now doing $6 million in sales, prepared to release its new toy, the Burp Gun (named for the sound the automatic cap gun made when fired). ABC-TV approached the company and offered an exclusive 52-week sponsorship of a new program, The Mickey Mouse Club. Toy advertising at that point was primarily catalogs and trade ads, and was backloaded toward Christmas. Television was still a new medium, and ABC's price tag was a steep, noncancelable $500,000, which was about Mattel's net worth. But the Handlers were intrigued. They consulted their number cruncher. If this fails, they asked, will we be broke? "Not broke," he replied, "but badly bent." That was enough of a comfort zone for the risk-taking Ruth and Elliot, who agreed to ABC's terms within the hour. "We're all in the entertainment business," says toymaker Chuck Hoberman, who created the interactive Hoberman Sphere. "But Mattel realized it first."

The Mickey Mouse Club debuted Oct. 3, 1955, and became an immediate ratings powerhouse, but the couple didn't see any impact on sales for weeks. The Monday after Thanksgiving, though, Mattel was swamped with Burp Gun orders, and ultimately it shipped more than one million that Christmas at $4 a pop. Their momentary panic resulted from a lapse in communication: The manufacturer was slow to learn from the middlemen and factory reps how its toys were selling. Once things calmed down, Ruth sought to remedy that industry failing. She developed a system to help predict and track sales, including weekly reports widely copied throughout the toy biz, and she established a "retail detail" team that visited stores to set up displays and check on products. "Television speeded everything up," said Ruth. "We reduced our lag time from six weeks to six minutes." That was fortunate since Mattel was about to transcend the business world and become a pop-culture juggernaut.

Arguably the single most important moment in the history of the American toy industry took place in 1956 in Switzerland, where the Handlers were vacationing. While shopping, Ruth discovered a strikingly adult doll named Lilli, complete with a curvaceous figure and high heels. Although Ruth didn't realize it at the time, Lilli was based on a prostitute from a German adult cartoon and intended for grown men. Ruth had been trying for years to persuade Mattel's designers to create a three-dimensional adult doll, and now she had a model. She had seen her daughter, Barbara, and her friends play with adult paper dolls, preferring them to three-dimensional baby dolls, her alternative. They'd play make-believe and mimic the conversations of their parents. "They were using the dolls to project their dreams of their own futures as adult women," Ruth realized. But she'd met with resistance from the company's engineers--all men--who told her that the doll would be too expensive to produce, and from the firm's ad agency, which worried that a voluptuous doll might be too sexy. Rarely spoken but usually implicit in the protests was the fact that Ruth had never designed a single toy. Why couldn't she stick to sales and marketing?

Ruth insisted that Mattel's development team create something similar to Lilli, and they resolved the cost issue by having the doll produced in Japan. The result, after nearly three years of design work, was Barbie, named after Ruth and Elliot's daughter (who was less than thrilled about the homage). The doll, officially named Barbie Teenage Fashion Model in the false hope that making her a teenager desexualized her, debuted at 1959's Toy Fair and was a "crashing bomb," according to the New York Times. Buyers--again, all men--immediately objected to the doll's breasts, which were unlike anything the industry had seen before (her measurements are usually projected as 39-21-33). The influential Sears buyer flatly refused to place an order, and those who agreed to carry Barbie did so cautiously. "Eighty percent who saw it said, 'The American public will not buy it,'" admitted Ruth. A then-unprecedented $12,000 market-research test also found mothers hating the doll, even though girls loved her. Ruth and Elliot, disappointed but resigned, grudgingly lowered their sales projections and reduced their factory orders further.

That turned out to be a huge mistake, since Ruth had been right all along: In 1959 girls snapped up 351,000 Barbie dolls at $3 apiece, making the doll a smash hit. Mattel added factory capacity and warehouse space and still couldn't keep up. "It took us three years to even come close to catching up with the demand a little bit," said Ruth. Investors liked Barbie too: Mattel went public in 1960, selling shares at $10 each. The company rocketed from $18.3 million in revenues in 1960 to $211 million in 1969, with profits peaking in 1970 at $17.4 million. And that $10 share was worth $522.50 at the stock's height in 1971. A lot of that, of course, hung on the strength of Barbie and her innumerable outfits and accessories. According to The Barbie Chronicles (1999), if Barbie's clothing counted toward the apparel market, Mattel would be America's fourth-largest women's wear manufacturer. As Elliot devilishly acknowledged, "You get hooked on one, and you have to buy the other. Buy the doll, and then you buy the clothes. I know a lot of parents hate us for this, but it's going to be around a long time."

Mattel continued to innovate throughout the 1960s in the wake of Barbie's success. Chatty Cathy, a talking baby doll, was a big hit in 1960 because of its string-activated voice box that caused her to talk. Mattel later defied the industry's conventional wisdom about educational toys being duds by using the same voice box to successfully launch its See 'N Say products in 1965. And the company again refreshed a toy category in 1968 with Hot Wheels, taking the staid die-cast metal miniature car and adding moving wheels and "hot California colors and styling." In 1967 miniature cars were a $23 million segment of the toy business. Mattel sold $25 million worth of Hot Wheels in 1968, and they, like Barbie, remain a Mattel staple to this day.

Hot Wheels were the Handlers' last big hit and, ironically, the product that precipitated the beginning of their end at Mattel. A battery-powered Hot Wheels line called Sizzlers fizzled, and the company's unrealistically high sales projections for it led to a glut of product. Not wanting to alert investors to the company's first big stumble, executives overzealously used accounting practices to hide the losses. At the same time, in keeping with the business trend of the late 1960s, the Handlers diversified, growing by acquisition into related fields. Mattel bought a pet-supply company and a playground maker, and most famously it purchased the Ringling Brothers--Barnum & Bailey Circus for $47 million in 1970. All of those had more problems than the Handlers initially realized. The company posted its first-ever loss in 1971, but the Handlers remained optimistic about the future. That ultimately led to their departure from Mattel, as a subsequent loss the next year startled the investment community and led to a wave of shareholder lawsuits and an SEC inquiry. The Wall Street Journal reflected the attitude about the company in 1973 by printing the joke "Have you heard about Mattel's new talking doll? Wind it up, and it forecasts a 100% increase in sales and profits. Then it falls flat on its face."

Whether or not the Handlers were directly responsible for the accounting irregularities at Mattel is unclear. Ruth and Elliot repeatedly denied that they knew what was going on, charging that some of the executives brought in to help manage growth managed instead to orchestrate their fall. "I wasn't a financial pro, and I paid the price," Ruth said in her 1998 FSB interview. She also pointed to her mastectomy in 1970 as having affected her ability to be as assertive as she needed to be. Nonetheless, the Handlers, and particularly Ruth, took the blame and suffered the consequences. They were forced out of Mattel in 1975, and they sold half their stock, 2.5 million shares, to help the company pay off the shareholder suits. Ruth was indicted in 1978 for falsifying financial statements; she pleaded no contest while maintaining her innocence, and received a suspended sentence, a $57,000 fine, and 2,500 hours of community service.

The toy community slowly reaccepted the Handlers as legends after demonizing them because of the scandal. They were invited to the inaugural Toy Industry Hall of Fame ceremony in 1984 and were inducted five years later. The Handlers, while appreciative, had moved on. Elliot, now 87, has spent his life in retirement concentrating on painting, and no longer grants interviews. Ruth retained her entrepreneurial drive, creating in 1976 Nearly Me, a better breast prosthesis for herself and other mastectomy patients. She later sold her company--Ruthton (she finally got her name in there)--to a division of Kimberly-Clark 15 years later. She died last year at 85, but the irony of her career path was never lost on her. As she liked to say when describing the route from Barbie to Nearly Me, "I've gone from breast to breast."