Go to the same NPC as you would to craft, and choose the Decompose option. You will not even see that option unless you have skill in that Craft.
Once you choose it, and add the item, you can see your skill, and the skill required to decompose the item. For the first four levels of crafting, the skill required is half that of the item's level, so a level four crafter can decompose level eight items. After that, it goes up one level for one level: a level five crafter can decompose items up to level Nine, and a level six crafter can decompose level 10 and so on.
Level seven crafting is enough to decompose most drops from normal creatures; most do not drop items above level 11. Even the high level Auspicious Ring: Order) from Twilight Temple (TT) is crafted from the decomposed remains of the Auspicious Ring from that same dungeon, which is only level 10. Another example: the Cloud Stir is level 15, but its parts require decomposition of only a level 11 item.
If decomposition for Chi is the primary goal of your crafting, and you must choose between which crafts to advance furthest, then concentrate your efforts on the Tailor craft first, then the Craftsman. Armor is the most frequent drop, and then Ornaments a distant second. Weapon drops are extremely rare
Level 1 or zero items, such as those dropped in Celestial Vale, cannot be decomposed. Level 2 and 3 ones yield the lowest, Lv. 1 Yiyuan Chi Stone, which is actually quite valuable as it is used as much or more in recipes than the level 2-9 Stones. Level 4 items decompose to Liangyi, and 5 to Santsai, etc.
There is no way, it seems, to Decompose three star gear of level 5 and lower. This may even be true of level 6 or even higher.
Unlike most interactions with objects spawning in inventory, a free inventory slot is not needed to convert an item into Chi stones; the stone merely replaces the item, unless there is a stack of that stone type already in inventory, in which case the new stones add to the stack.
Twilight Temple Gear must be repaired to full before it can be Decomposed to become a Souledge