In their factory

Both are correct, but avoid the second one because their could refer to children. No rational person would be misled to think that small children own a factory, but that's no justification for misplacing a modifier.

Thank you very much Aspara Gus.

I had not thought of that interpretation. I thought "2" was ambiguous because it could also mean:

They make toys for small children who are (live) in their factory.

Consider:
She made sandwiches for small children in her daugher's school.

Gratefully,
Navi.

She made sandwiches for small children at her daughter's school.

I think at is better here. I sense no ambiguity.

Thanks again Aspara Gus.

Well, it seems to me that technically there could be ambiguity because it is possible that she made the sandwiches at the school. Does "at her daughter's school" postmodify "children" ("children who were at her daughter's school") or is it a place adverbial (she made sandwiches at her daughter's school for children).

Consider:
She made toys for childr

navitasanWell, it seems to me that technically there could be ambiguity because it is possible that she made the sandwiches at the school.

Yikes! That's exactly how I interpreted the sentence! If that isn't the intended meaning, then the sentence is truly ambiguous.

Try something like this

She made sandwiches for her daughter's schoolmates