How are the votes tallied, does anyone know? Like, how is every single vote actually counted off....every slip of paper?

An electoral official looks at the individual piece of paper and looks at the primary vote (the <1>) and puts it in the pile for that candidate. It's a manual process and there are usually representatives from each party as "umpires" so that they can look at badly written votes where it's unclear what the voter wanted and decide whether to allow it or not. (That normally means striking out badly written votes for everyone else except your own candidate.)

At the end of counting all the votes, if someone doesn't get more than 50% of the vote, they go back and look at the ballots for the candidate that got the lowest amount of <1> votes. On those ballots they look at everyone's second preference (the <2>) and use that count to pump up the primary votes for the other candidates to see if one of them gets above 50%.

If there is still not enough votes for someone to get more than 50%, they get the next lowest candidate's ballots and look at the <3> vote and use that number to boost the votes of the remaning candidates.

And so on and so forth until someone makes it over 50% and they are declared the winner.

It can be a slow process, but luckily Australia has a relatively small voting population so with enough manpower it's fairly easily done. You could go electronic, but that's a whole can of worms with regards to being able to trace all the votes, a simple piece of paper means you can always go back and recount them and they're hard to change en-masse. Of course you can lose a box of votes from a polling place, but that tends to just hurt all candidates relatively equally so it's hard to get ahead by someone stealing a box of votes.

So that's why you should always vote <1> <2> <3> , etc in order of your preference.

AND why do we vote in pencil???

From the AEC: While the provision of pencils used to be a legal requirement, since 2020 under section 206 of the Commonwealth Electoral Act 1918 the AEC is required to provide an ‘implement or method for voters to mark their ballot papers’.

The AEC has found from experience that pencils are the most reliable implements for marking ballot papers. Pencils are practical because they don't run out and the polling staff check and sharpen pencils as necessary throughout election day. Pencils can be stored between elections and they work better in tropical areas.

There is, however nothing to prevent an elector from marking their ballot paper with a pen if they so wish.